5 - MS&E 241: ECONOMIC ANALYSIS Thomas A. Weber 5....

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MS&E 241: ECONOMIC ANALYSIS Thomas A. Weber 5. Choice Under Uncertainty Winter 2009 Stanford University Copyright © 2009 T.A. Weber All Rights Reserved -2- MS&E-241-Winter-2009-TAW AGENDA Elements of Probability Choice Under Uncertainty Expected Utility Theory Risk Aversion and Decision Biases Key Concepts to Remember
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-3- MS&E-241-Winter-2009-TAW So far in this course we have assumed that a consumer (decision maker) knows perfectly the consequences of choice. However, in most practical economic decision situations there is uncertainty. CHOICE UNDER UNCERTAINTY -4- MS&E-241-Winter-2009-TAW How much will my education help me in the job market? Will I be given valuable assignments if I accept this job offer? Is the used car I am buying a lemon? Or will it be dependable? If I put effort into developing a proposal, will it be accepted? Will an R&D program be successful? How capable is the person I am considering hiring? Will my competitors introduce superior new products? Will potential customers purchase the product I offer? Will I enjoy the movie? What will the weather be like in the city I plan to visit? Will my home catch on fire in the next year and be destroyed? Will the price of the stock I purchase go up or down? Will prices for commodity go up or down? Fixed price contract? If I take a litigation to trial, rather than settling, will I win? UNCERTAINTY IN CHOICE Some Examples
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-5- MS&E-241-Winter-2009-TAW RISK VS. UNCERTAINTY Distinction between risk and uncertainty due to Frank Knight (1921): Uncertainty : unknowable (e.g., the success probability of your new startup company, or the likelihood of an unforeseen contingency in your project) Risk : knowable (e.g., the outcome of a die roll) “The practical difference between the two categories, risk and uncertainty, is that in the former the distribution of the outcome in a group of instances is known (...), while in the case of uncertainty this is not true , the reason being in general that it is impossible to form a group of instances, because the situation dealt with is in a high degree unique” (p. 233) “We can also employ the terms “objective” and “subjective” probability to designate the risk and uncertainty respectively, as these expressions are already in general use with a signification akin to that proposed” (ibid.) In this course, no explicit distinction between risk and uncertainty , since in order to formally analyze optimal choice, need to introduce a probability space in either case . -6- MS&E-241-Winter-2009-TAW All would not necessarily agree on the likelihood of events - Probability relevant for your decision is determined by all your knowledge - Most economic situations can best be described by subjective probabilities Will the used car be a lemon? Or will it be dependable?
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5 - MS&E 241: ECONOMIC ANALYSIS Thomas A. Weber 5....

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