The Theory of Probability in Economics

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Variables influence all economic activity. Incomes and prices, for example, are known at the present with certainty, but that certainty declines as you try to plan your own economic activity. This is most obvious in investing: all the research in the world cannot guarantee that a particular stock will increase -- or decrease -- in value in the coming weeks and months. Thus, not knowing the future implies risks. By assessing the probability of these risks, you can decide how much of it you want to assume.

Objective Probability

If you have knowledge from previous experiences of how often an event has occurred, or if you can access information on how often it has happened to others, you can calculate probability. This can be done in many ways. For example, if you have bought a scratch-off lottery ticket and wonder what the probability of winning is, you learn how many tickets are printed overall and how many of them are winners. The ratio of winners to the number of tickets printed is your probability of winning a prize. For instance, if a million tickets are printed, and 100,000 of them are winners of some amount and one is the grand prize winner, then your overall odds of winning are 1 in 10, and your odds of winning the grand prize are one in a million.

Expected Values

You can also assess the expected values of uncertain situations by using a weighted average of the payoffs associated with outcomes. In order to do this, you calculate the probability of success and multiply it by the outcome associated with success. You then calculate the probability of failure and multiply it by the outcome associated with failure. By adding your two answers, you will have the expected average value of the payoff.

Subjective Probability

Sometimes there is no previous experience or useful statistical information to help you to make an objective decision. In this case, you must rely on perception. You may base your perception on judgment or general experience, but it cannot be based on the previous frequency of occurrence because this information is not available to you. Because of this, your decisions will be subjective and different from those made by others because their information, and their perceptions, are different. This makes the judgment more speculative and risky.

Evaluating Objective and Subjective Probability

People do not always evaluate uncertain events by applying the laws of probability, nor of utility – satisfaction – rationally. You may, for example, have an exaggerated belief that you will have an accident or that you will succumb to a particular illness. Investors often have an exaggerated belief that stock markets will continue to rise or fall, or that real estate prices will always rise, despite the objective and subjective probabilities that this belief is highly unlikely to be true.