CHAPTER 12. UNCERTAINTY
, insurance of 10,000 Baht, by paying
, 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
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
Baht of insurance and has to pay
a premium of
, then he will face a gamble:
Probability of .01 of getting:
Probability of .99 of getting:
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
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