Week 3b Lecture_Uncertainty

Week 3b Lecture_Uncertainty - Week 3 Uncertainty Choices...

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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. State-Contingent 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. State-Contingent Budget Constraints C na C a 20 17 A state-contingent consumption with $17 consumption value in the accident state and $20 consumption value in the no-accident state. State-Contingent Budget Constraints Without insurance, C a = m - L C na = m. State-Contingent Budget Constraints C na C a m The endowment bundle. m L- State-Contingent 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 State-Contingent Budget Constraints C na C a m The endowment bundle. Where is the most preferred state-contingent 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.

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Week 3b Lecture_Uncertainty - Week 3 Uncertainty Choices...

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