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CHAPTER 18 UNCERTAINTY AND RISK AVERSION Most of the problems in this chapter focus on illustrating the concept of risk aversion. That is, they assume that individuals have concave utility of wealth functions and therefore dislike variance in their wealth. A difficulty with this focus is that, in general, students will not have been exposed to the statistical concepts of a random variable and its moments (mean, variance, etc.). Most of the problems here do not assume such knowledge, but the Extensions do show how understanding statistical concepts is crucial to reading applications on this topic. Comments on Problems 18.1 Reverses the risk-aversion logic to show that observed behavior can be used to place bounds on subjective probability estimates. 18.2 This problem provides a graphical introduction to the idea of risk-taking behavior. The Friedman-Savage analysis of coexisting insurance purchases and gambling could be presented here. 18.3 This is a nice, homey problem about diversification. Can be done graphically although instructors could introduce variances into the problem if desired. 18.4 A graphical introduction to the economics of health insurance that examines cost-sharing provisions. The problem is extended in Problem 19.3. 18.5 Problem provides some simple numerical calculations involving risk aversion and insurance. The problem is extended to consider moral hazard in Problem 19.2. 18.6 This is a rather difficult problem as written. It can be simplified by using a particular utility function (e.g., U ( W ) = ln W ). With the logarithmic utility function, one cannot use the Taylor approximation until after differentiation, however. If the approximation is applied before differentiation, concavity (and risk aversion) is lost. This problem can, with specific numbers, also be done graphically, if desired. The notion that fines are more effective can be contrasted with the criminologist’s view that apprehension of law- breakers is more effective and some shortcomings of the economic argument (i.e., no
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This note was uploaded on 11/06/2009 for the course ECON ECON111 taught by Professor Smith during the Spring '09 term at Punjab Engineering College.

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