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,
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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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 Spring '10
 YY
 Economics, Microeconomics, Utility, insurance company, baht

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