Friday, October 17, 2014

Risk Management

This past week, we have taken a look at the economics behind future risk management from the perspective of a rational actor. The model we have discussed makes assumptions such as perfectly rational behavior and knowledge of various potential outcomes, but it is highly descriptive when it comes to seeing how people act in the face of risk and uncertainty. In my own life, I have already taken many steps to reduce future risks, primarily in terms of my intended career path. While some of my decisions have been well planned and intentional, I'm certain that other actions have been indirectly determined by my personal level of risk aversion, despite not always knowing the likelihood of specific outcomes. For example: my choice to attend college. Although it does not take much convincing to explain why college generally improves one's potential outcomes (employment, financial security, etc.), I never really examined what going to college really meant until I got here.

When I was a freshman in introductory microeconomics, I was introduced to the concept of opportunity cost. One of the examples the professor used to illustrate the idea was his students' decision to pursue a university degree. In an economic sense, the total cost of a college education includes not only the direct monetary cost of tuition, but also the highest value alternative that could have been pursued. With tuition costing in the ball park of $30,000 per year in addition to the amount of money I could have made working in a minimum wage position for four years, college is quite an expensive ordeal. I am one of the students lucky enough to have my parents pay my tuition, but even still why would I choose to forgo several years of income to attend class and earn nothing? The answer, as you may have suspected, is my expected outcome in the years following college. Instead of choosing to end my education following high school and starting to accumulate income with relative certainty, I took a path with greater uncertainty in exchange for a lower risk. I am still unemployed as I approach my graduation date, but there is a greater chance of me finding a suitable career with more competitive than if I had not chosen to attend college.

Another example of such behavior I have seen is my older sister's decisions following her college graduation. She is seven years older than I am, and is a University of Illinois alumnus. After making a similar decision to attend college rather than taking low paying but certain income, she began work for Delta Airlines as an analyst after her graduation. Then, after a few years of working, she decided to quit her job and pursue an MBA. Despite having a rather comfortable income after college, she did not have enough saved to pay for business school at Duke Fuqua School of Business. So, she took out student loans and took on a great deal of debt. She has since earned her MBA and found a job as a marketing manager with nearly double the income she had working at Delta. In other words, the potential value of improvement in her position brought about by earning an MBA was worth far more to her than the monetary value of her student debt and the forgone income from quitting her job.

While these examples are slightly more abstract than the insurance model we have been using to describe risk aversion and management, I think that both my sister's and my decisions regarding our educational paths are strong real-life examples of rational agents choosing a higher long-run payoff that is less certain over lower short-run payoffs that are more certain.

2 comments:

  1. I liked your last paragraph. It means you (and your sister) have actually taken on income risk, but that's because the increase in expected income is sufficiently great. Many of your classmates have written as if the idea is to reduce income risk, because most of us are risk averse. The risk aversion implies only that we want to reduce unfavorable income risk. There is some income risk we will take on, because it is attractive to do so.

    Without knowing other things about your sister, I can't say whether the MBA was rational or not. Might she have advance in her then current position at Delta without or found the new job without the MBA? It is good that things seemed to work out for her, but as to whether the choice was rational or not, you need to know about the road not taken as the well as the one arrived upon.

    Switching gears, in the current labor market it doesn't seem to me to be a tough call about going to college, if you have the grades and test scores to get into a decent place like the U of I. There are some people who do fabulously well without a college degree, and we'll talk about that on Tuesday. But on average earnings for high school grads are not high, and when you started college the unemployment rate for new high school grads was quite high. So the opportunity cost of attending college, as distinct from the direct tuition part, was actually pretty low. The direct tuition part has become quite expensive and is its own issue. It blocks some people from going to college, who would otherwise benefit from it. That is a shame.

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  2. Thank you for your feedback Professor Arvan. After our discussion last Tuesday, it makes a lot more sense to me why people like my sister and myself are actually willing to assume greater levels of income risk despite being (generally) risk averse individuals. Since the expected payoff of attaining higher education is sufficiently high, it is clear why we are willing to forgo certain income today for less certain, but potentially much greater income tomorrow. In regards to the opportunity cost of my choice to attend college rather than work directly after high school, it makes sense that the opportunity cost was actually quite low. As you mentioned in class, some individuals such as Mark Zuckerberg and Steve Jobs choose to abandon the traditional path to "success" since their opportunities are so high outside of education. Unfortunately for most of us, such incredible outcomes are the exception and most certainly not the rule. The poor job market and employment outlook when I finished high school in 2011 were abysmal, and that likely has something to do with how little thought it took for me to realize that college was the best decision for my future in terms of income.

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