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Learning goals
• Identify 3 sources of income/consumption risk for the poor.
• Define risk aversion.
• Outline the model of perfect insurance AND
• Identify 3 reasons why this model fails in developing countries.
• Identify 2 ways in which households in developing countries self-
insure.
• Explain how households use credit as insurance.
• Identify 2 reasons why insurance programs for the poor have not
been successful.
Source: Jayachandran (2006)
Coping with Risk
• The poor often find clever ways to cope with risk:
1. Diversify: many occupations, other than agriculture
2. Holding multiple plots
3. Migration
4. Marriage
5. Risk-sharing
• ROSCAs
• (informal) Insurance
• Credit
Insurance is welfare-improving because
people are risk averse
•What is risk aversion?
• It is the reluctance of a person to accept a bet with an
uncertain payoff rather than another bet with a more
certain, but possibly lower, expected payoff.
Gamble A Gamble B
50% chance: $50 $10
50% chance: $50 $100
Expected value: $50 $55
Why are people risk averse?
• Decreasing marginal utility:
• Utility from a dollar when you are poor is much
higher than the utility from a dollar when you
are rich.
Decreasing marginal utility and risk aversion
Consumption
Utility
Decreasing marginal utility and risk aversion
Consumption
Utility
100 500
U(100)
U(500)
• Marginal utility is the
slope of the curve
• MU at U(500) < MU
at U(100)!
Decreasing marginal utility and risk aversion
•Assume a 50-50 chance of a random shock:
• 50% chance that consumption = 100
• 50% chance that consumption = 500
•Expected value (of consumption) = (0.5*100) +
(0.5*500) = 300
•Expected utility = 0.5*U(100) + 0.5*U(500)
Decreasing marginal utility and risk aversion
Consumption
Utility
100 500
U(100)
U(500)
300
(Expected value)
0.5*U(100) + 0.5*U(500)
(Expected Utility)
Decreasing marginal utility and risk aversion
Consumption
Utility
100 500
U(100)
U(500)
300
(Expected value)
Expected Utility
Utility of Exp. Value: U(300)
Utility of Expected Value
>
Expected Utility
Decreasing marginal utility and risk aversion
Utility of Exp. Value: U(300)
Indifferent between Y*
and the expected value,
because they both give the
same utility
Consumption
Utility
100 500
U(100)
U(500)
300
(Expected value)
Expected Utility
Y*
The cost of the risk: Part 1
Utility of Exp. Value: U(300) •Y* is the certainty equivalent
•300 – Y* is the “cost of risk”
• what you would be
willing to pay to insure
against the risk
Consumption
Utility
100 500
U(100)
U(500)
300
(Expected value)
Expected Utility
Y*
Why insurance is welfare-improving
• Suppose a good outcome is H and a bad outcome L
• H occurs with probability p, and L with probability 1-p
• Expected utility under this framework:
• EU = p*U(H) + (1-p)*U(L)