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The economics of flood insurance
The economics of flood insurance

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3.1 The functioning of markets

The headlines in Figure 6 are commonplace in the world today. These days the existence of the forces of demand and supply is taken for granted. It is accepted that markets typically determine the prices paid for everything from fruit and veg to petrol and property and even the pay for labour. The dominant ideology today is that this price mechanism is the most efficient way to allocate resources, provided that markets trade freely. The underlying premise for this claim is that price encapsulates all the relevant wishes and intentions of buyers and sellers, so a market is essentially an information network.

A compilation of four news headlines. From top to bottom, the first one reads: Abu Dhabi property close to demand-supply balance., 27 November 2019. The second one: Huge demand for Egyptian onions, price nearly doubled in 45 days,, 26 November 2019. The third: LNG prices in Asia plunge 43% as new US supply hits market, Nikkei Asia Review, 26 November 2019. The last one: UK employment rate hits record high as wages surge higher, ITV News, 10 September 2019.
Figure 6 The price mechanism in action

Suppliers of goods and services are assumed to be ‘profit-maximisers’. In other words, they are motivated to sell as much as they can as long as that increases their profits. Therefore, they will carry on selling more up to the point at which the revenue they get from selling one more unit – called marginal revenue– equals the additional cost of producing that unit – called marginal cost.

Buyers are assumed to be ‘utility-maximisers’ – in other words they will carry on buying more for as long as their utility (pleasure of satisfaction) from doing so is rising. So an individual or household will want to carry on consuming up to the point at which the pleasure they get from consuming the last unit – called marginal utility just equals the cost to them of buying that unit.