(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 196

CHAPTER 5 • Uncertainty and Consumer Behavior 171

TABLE 5.5

INCOME FROM SALES OF APPLIANCES ($)
HOT WEATHER

COLD WEATHER

Air conditioner sales

30,000

12,000

Heater sales

12,000

30,000

single product. Suppose there is a 0.5 probability that it will be a relatively hot
year, and a 0.5 probability that it will be cold. Table 5.5 gives the earnings that
you can make selling air conditioners and heaters.
If you sell only air conditioners or only heaters, your actual income will be
either $12,000 or $30,000, but your expected income will be $21,000 (.5[$30,000]
ϩ .5[$12,000]). But suppose you diversify by dividing your time evenly between
the two products. In that case, your income will certainly be $21,000, regardless
of the weather. If the weather is hot, you will earn $15,000 from air conditioner
sales and $6000 from heater sales; if it is cold, you will earn $6000 from air conditioners and $15,000 from heaters. In this instance, diversification eliminates
all risk.

Of course, diversification is not always this easy. In our example, heater and
air conditioner sales are negatively correlated variables—they tend to move
in opposite directions; whenever sales of one are strong, sales of the other are
weak. But the principle of diversification is a general one: As long as you can
allocate your resources toward a variety of activities whose outcomes are not
closely related, you can eliminate some risk.
THE STOCK MARKET Diversification is especially important for people who
invest in the stock market. On any given day, the price of an individual stock
can go up or down by a large amount, but some stocks rise in price while others fall. An individual who invests all her money in a single stock (i.e., puts all
her eggs in one basket) is therefore taking much more risk than necessary. Risk
can be reduced—although not eliminated—by investing in a portfolio of ten or
twenty different stocks. Likewise, you can diversify by buying shares in mutual
funds: organizations that pool funds of individual investors to buy a large number of different stocks. There are thousands of mutual funds available today
for both stocks and bonds. These funds are popular because they reduce risk
through diversification and because their fees are typically much lower than the
cost of assembling one’s own portfolio of stocks.
In the case of the stock market, not all risk is diversifiable. Although some
stocks go up in price when others go down, stock prices are to some extent
positively correlated variables: They tend to move in the same direction in
response to changes in economic conditions. For example, the onset of a severe
recession, which is likely to reduce the profits of many companies, may be
accompanied by a decline in the overall market. Even with a diversified portfolio of stocks, therefore, you still face some risk.

Insurance
We have seen that risk-averse people are willing to pay to avoid risk. In fact, if
the cost of insurance is equal to the expected loss (e.g., a policy with an expected
loss of $1000 will cost $1000), risk-averse people will buy enough insurance to
recover fully from any financial losses they might suffer.

• negatively correlated

variables Variables having a
tendency to move in opposite
directions.

• mutual fund Organization
that pools funds of individual
investors to buy a large number
of different stocks or other
financial assets.

• positively correlated
variables Variables having a
tendency to move in the same
direction.