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Unformatted text preview: Week 3 Uncertainty Choices over uncertain objects Choices over actions that will lead to multiple possible outcomes Action 1: go on a road trip; Action 2: stay at home. Possible states of Nature: car accident (a) no car accident (na). Accident occurs with probability a , does not with probability na ; a + na = 1. StateContingent Budget Constraints Each $1 of accident insurance costs . Consumer has $m of wealth. C na is consumption value in the no accident state. C a is consumption value in the accident state. StateContingent Budget Constraints C na C a 20 17 A statecontingent consumption with $17 consumption value in the accident state and $20 consumption value in the noaccident state. StateContingent Budget Constraints Without insurance, C a = m  L C na = m. StateContingent Budget Constraints C na C a m The endowment bundle. m L StateContingent Budget Constraints Buy $K of accident insurance. Price per dollar of insurance 0 < <1. C na = m  K. C a = m  L  K + K = m  L + (1 )K. So K = (C a  m + L)/(1 ) And C na = m  (C a  m + L)/(1 ) I.e. C m L C na a = 1 1 StateContingent Budget Constraints C na C a m The endowment bundle. Where is the most preferred statecontingent consumption plan? C m L C na a = 1 1 slope =  1 m L m L Sell insurance Preferences Under Uncertainty Think of each option as a lottery. Win $90 with probability 1/2 and win $0 with probability 1/2. If the preference is rational, cts and satisfies independence axiom then it can be represented by expected utility . E.g. u($90) = 12, u($0) = 2. Expected utility is . 7 2 2 1 12 2 1 u($0) 2 1 u($90) 2 1 EU = + = + = Mixing Lotteries If A happens with probability 1/5 and B happens with probability 4/5, whats the resulting lottery?...
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This note was uploaded on 09/06/2010 for the course FBE ECON2113 taught by Professor Franchsica during the Fall '09 term at HKU.
 Fall '09
 Franchsica

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