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Unformatted text preview: Introduction to the Economics of Uncertainty and Information Timothy Van Zandt INSEAD November 2006 Copyright November 2006 Preliminary and incomplete: Use only with the permission of the author. Authors address: INSEAD Boulevard de Constance 77305 Fontainebleau CEDEX FRANCE Voice: +33 1 6072 4981 Fax: +33 1 6074 6192 Email: tvz@insead.edu WWW: faculty.insead.edu/vanzandt Table of Contents 1 Introduction to decision theory 1 1.1 Why individual decision theory in economics? . . . . . . . . . . . . . 1 1.2 Descriptive, prescriptive and normative theories . . . . . . . . . . . . 1 1.3 A review of choice, preferences and utility . . . . . . . . . . . . . . . 2 2 Lotteries and objective expected utility 7 2.1 Simple and compound lotteries . . . . . . . . . . . . . . . . . . . . . 7 2.2 The Independence Axiom . . . . . . . . . . . . . . . . . . . . . . . . 10 2.3 First-order stochastic dominance . . . . . . . . . . . . . . . . . . . . 19 2.4 Continuity Axiom . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 2.5 Expected Utility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 3 States of nature and subjective expected utility 31 3.1 States, actions and outcomes . . . . . . . . . . . . . . . . . . . . . . 31 3.2 From large worlds to small worlds . . . . . . . . . . . . . . . . . . . . 31 3.3 Outcomes and state-independent preferences . . . . . . . . . . . . . 35 3.4 Objective expected utility . . . . . . . . . . . . . . . . . . . . . . . . 37 3.5 Subjective expected utility . . . . . . . . . . . . . . . . . . . . . . . . 38 3.6 Statewise dominance . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 4 Choosing when there is new information 41 4.1 Representing information . . . . . . . . . . . . . . . . . . . . . . . . 41 4.2 Bayes Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46 4.3 Independence and Exchangeability . . . . . . . . . . . . . . . . . . . 58 5 Risk Preferences 65 5.1 Money outcomes and risk aversion . . . . . . . . . . . . . . . . . . . 65 5.2 Comparing the risk aversion of people . . . . . . . . . . . . . . . . . 74 5.3 Comparing the riskiness of acts . . . . . . . . . . . . . . . . . . . . . 77 6 Market Decisions in the Presence of Risk 89 6.1 Demand for a state-contingent contract . . . . . . . . . . . . . . . . 89 6.2 Techniques for characterizing market decisions . . . . . . . . . . . . 94 6.3 Comparative statics . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109 6.4 State-dependent utility . . . . . . . . . . . . . . . . . . . . . . . . . . 116 7 Markets for state-contingent contracts 121 7.1 Gains from sharing risks . . . . . . . . . . . . . . . . . . . . . . . . . 122 7.2 Insurance market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130 Economics of Uncertainty and Information November 2006 Timothy Van Zandt ii Economics of Uncertainty and Information 8 Asset Markets 135 8.1 The nature of asset markets . . . . . . . . . . . . . . . . . . . . . . . 135 8.2 8....
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EconInfo-Book - Introduction to the Economics of...

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