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Risk and uncertainty

Risk and uncertainty defined

Risk describes situations where there is uncertainty about which outcome will eventuate, but the range of all possible events is known and outcomes can be assigned a probabilistic value. On the other hand, uncertainty describes situations where the probabilities are unknown. There could be uncertainty about what events are possible as well as insufficient information to assign probabilities to their outcomes (Majone, OECD, 2006).

Expected utility theory is a framework for analysing choices involving uncertainty.

The framework often used by economists for the analysis of choices involving uncertainty is expected utility theory[1]. Majone (OECD, 2006) defines risk as an expected loss (or negative utility), which can be calculated once we know the probability distribution of all possible events. The individual has a utility function, which measures the value to them of each course of action when each of the uncertain possibilities is assumed to be the true one. They also have a “subjective probability distribution”, which expresses quantitatively their beliefs about uncertain events.

The decision rule based on this approach is that: the individual’s optimal decision is the one that maximises expected utility (or minimises expected loss) with respect to this probability distribution.

Advantages associated with applying a decision rule to maximise utility

The major advantage of applying a decision rule that aims to maximise expected utility is that it encourages the risk regulator to analyse all relevant dimensions of the problem, including not only the nature of the risk and the benefits of minimising the risk, but also the costs, which may otherwise be overlooked[2]. It is a holistic approach that acknowledges that most risk assessments are subjective and offers a way of consistently revising and updating such assessments in light of new information.

Expected utility theory has received some criticism. In practice, people may not choose under uncertainty to update their beliefs in the manner prescribed by the theory. The perceived importance of a risk may not be based on the likelihood of an occurrence. Instead, public perceptions may be influenced by: the severity of impact (even if the likelihood is low); whether they have control over the exposure to risk; whether the effect is immediate or delayed; whether future generations will be affected; and cultural factors such as “view of the world”.

However, faced with uncertainty, the economist can still contribute in various ways (Winpenny, OECD, 1995) by:

  • making the case for investment in information
  • presenting the various possible outcomes, with their probabilities, as our knowledge improves (risk assessment)
  • taking into account the perceptions and preferences of the decision-maker and/or the general public (risk perception and subjective preferences)
  • devising appropriate decision rules and/or principles and investment strategies (risk management).

Decision-making principles direct attention to opportunity costs and regulatory priorities.

Decision-making principles can be useful in directing attention to the importance of opportunity costs (associated with action and inaction) and regulatory priorities. This learning process can, in turn, change the practice of regulatory agencies.

Precautionary principle

Definition of the precautionary principle

There are numerous definitions and interpretations of the precautionary principle, which are discussed later in the paper. The most widely quoted was introduced at the 1992 United Nations Conference on Environment and Development (Rio Declaration, Principle 15):

“Where there are threats of serious or irreversible damage, lack of full scientific evidence shall not be used as reason for postponing cost-effective measures to prevent environmental degradation.”

The triggering factor is the “threat” of serious or irreversible damage, although this has not been defined, leaving governments to decide what measures to take on a case-by-case basis.

Precautionary principle focuses on uncertainty and irreversibility.

The precautionary principle comes into its own where the parties are very risk averse, or where decisions have to be taken in the face of scientific uncertainty over potentially serious environmental impacts and/or irreversible threats of harm (eg, climate change, or the inadvertent release of a genetically modified organism). This could be accompanied by the existence of a long time-lag before some potential effects become apparent and may include threshold effects that cause sudden changes in state. Values may also be an important component where people have entrenched views that are not necessarily informed by available scientific information.

Because there is a range of precautionary approaches that could be applied under conditions of risk and uncertainty[3], the precautionary principle needs to be considered in the context of a broader risk management framework.

Notes

  • [1]Although the expected value approach is widely used in the analysis of choices involving uncertainty, this is a special case in the expected utility model, when the utility is a linear function of wealth. Normally, under expected utility theory, the utility function is concave, characterising risk aversion (Quiggan, 2005).
  • [2]There are other decision rules, for example, minimax, which focuses on losses (ie, consequences under the worst-case scenario) but not on probabilities, while others focus on probabilities; for example, the risk classification method. The expected utility rule takes account of both losses/utility and probabilities (Majone, 2006; Quiggan, 2005).
  • [3]Winpenny (OECD, 1995) also refers to other decision-making rules. See page 141.
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