Published online by Cambridge University Press: 05 June 2012
Risk is a factor that is evident throughout economic activity. Firms must choose between investment plans for which neither the cost nor the return can be known with certainty, households purchase goods whose value in use is determined by the state of nature and the government receives uncertain revenues and allocates funds to projects with unknown outcomes. Although the Arrow–Debreu economy is capable of incorporating risks of these kinds, so that they can be viewed as having already been covered by previous analysis, the special features involved with risk justify a separate chapter devoted to the subject.
The interpretation of the Arrow–Debreu economy in the presence of risk is discussed first and the Pareto optimality of equilibrium is reconsidered with particular focus placed upon the number of markets necessary to sustain optimality. This analysis is at the level of generality of previous chapters. The reasons why there may be too few markets to sustain optimality and whether this may justify government intervention are also considered. Individual attitudes to risk, in terms of measures of risk aversion, are then contrasted to social attitudes. Alternative perspectives on social attitudes, including the Arrow–Lind theorem supporting risk neutrality of government, are contrasted. A more general framework is then presented which shows how social attitudes to risk can be derived from the social insurance effects of projects and the weighting of households in the social welfare function.
A more specific interpretation of risk in terms of assets with random returns is then adopted and household maximisation is analysed in further detail.