Ch12 - Chapter 12 Uncertainty In this chapter we study...

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Chapter 12 Uncertainty In this chapter we study individual behavior with respect to choices involv- ing uncertainty. 12.1 Contingent Consumption A consumer is presumably concerned with a probability distribution of getting different consumption bundles. A probability distribution consists of a list of different outcomes - in this case, different consumption bundles - and the probability associated with each outcome. Let’s start with an example to introduce concepts and ideas. Suppose you have a computer worth 35,000 Baht. It is reasonable to assume that there is a possibility that something can go wrong with the computer and it loses value of 10,000 Baht, say, by damage or whatever. Assume that this probability is very small, 0 . 01. We can describe the situation more succinctly by saying that there are 2 possible outcomes, “computer worth 35,000 Baht” with probability 0 . 99 and “computer slightly damaged” with probability 0 . 01. Insurance offers us a way to change this probability distribution. Say there is an insurance company willing to pay 100 Baht insurance for pre- mium of 1 Baht. So, to cover the entire possible loss, a consumer would buy, 1
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2 CHAPTER 12. UNCERTAINTY K , insurance of 10,000 Baht, by paying γK , 100 Baht (i.e. for insurance 100 Baht pay 1 Baht premium, so for 10,000 Baht insurance pay 100 Baht.) The possible outcomes, or contingent consumption plan , is therefore, 1 percent chance of having 34,900 Baht (35,000 - 10,000 loss + 10,000 from insurance - 100 paid to insurance company), and a 99 percent chance for having 34,900 Baht (35,000 less 100 paid to insurance company). In this case, the consumer ends up with the same wealth whatever the outcome! He or she is fully insured against loss. In general, if a consumer purchases K Baht of insurance and has to pay a premium of γK , then he will face a gamble: Probability of .01 of getting: 25 , 000 + K - γK and Probability of .99 of getting: 35 , 000 - γK Whether the consumer actually chooses to fully insure himself or herself depends on his/her preferences. Whether the loss occurs or doesn’t are two states of nature , which are mutually exclusive and help define the contingent consumption plans. Consumers have different preferences over different plans of consumption, just like they preferences over actual consumption. We can show this in a diagram with two states of nature, the event
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Ch12 - Chapter 12 Uncertainty In this chapter we study...

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