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The Relevancy of Probability in Economics

Modern economics in addition to sophisticated mathematics also employs probability distributions. What is probability?  The probability of an event is the proportion of times the event happens out of a large number of trials.

For instance, the probability of obtaining heads when a coin is tossed is 0.5. This does not mean that when a coin is tossed 10 times, five heads are always obtained.

However, if the experiment is repeated a large number of times then it is likely that 50% will be obtained. The greater the number of throws, the nearer the approximation is likely to be.

Alternatively, say it has been established that in a particular area, the probability of wooden houses catching fire is 0.01. This means that on the basis of experience, on average, 1% of wooden houses will catch fire.

This does not mean that this year or the following year the percentage of houses catching fire will be exactly 1%. The percentage might be 1% or not each year. However, over time, the average of these percentages will be 1%.

This information, in turn, can be converted into the cost of fire damage, thereby establishing the case for insuring against the risk of fire. Owners of wooden houses might decide to spread the risk by setting up a fund.

Every owner of a wooden house will contribute a certain proportion to the total amount of money that is required in order to cover the damages of those owners whose houses are going to be damaged by the fire.

Note that insurance against fire risk can only take place because we know its probability distribution and because there are enough owners of wooden houses to spread the cost of fire damage among them so that the premium is not going to be excessive.

 

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