# IE-ch18 - 20101014 2 Today we will begin studying...

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2010 10 14 1 Chapter 18 Uncertainty and Risk Aversion Lecturer: Yu Wang 2 Today we will begin studying consumption (and investment) with risk. This is like consumption over time, only we are now worried about future uncertainty. 3 What Is Uncertainty? One could imagine approaching this question in many ways. We have a very general formulation for it in economics. Uncertainty means any situation in which there is a probability of more than one event occurring. 4 States of the World More formally, we think of this each of these events as a different state of the world. B f th t i t i l d d t k Before the uncertainty is resolved, we do not know which state we are going to end up in. These states of the world are mutually exclusive After the uncertainty is resolved, we are in one and only one of the states. 5 How Many States? In the real world there are practically infinitely many potential states of the world. Every event with an uncertain resolution (e.g. the flip of a coin) splits the world into more different states. Luckily we can ignore events that don’t affect us. If I only care about that flip of the coin, I can just consider two states: heads and tails. 6 States of the World: Examples Usually we will be dealing with very simple sets of states: I roll a die. There are 6 states of the world, 1 for each face of the die. 2 states of the world: your house burns down or it doesn’t. You need to make sure that your set of states exhaust all possible events. Not acceptable: the Yankees or the Cardinals win the World Series. Acceptable: the Yankees win the World Series or they do not.

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