Ch05_1 - CHAPTER5 TEACHINGNOTES ,butstudentsfindthe...

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Chapter  5:  Uncertainty and Consumer Behavior CHAPTER 5 UNCERTAINTY AND CONSUMER BEHAVIOR TEACHING NOTES Choice under uncertainty is an important topic in microeconomic theory, but students find the  concept difficult.  The topic should be covered in business-oriented courses, particularly if you intend  to cover the role of risk in capital markets, which is discussed in Chapter 15.  The primary purpose of  this chapter is to encourage students to think about the influence on behavior of attitudes toward risk.  The first three sections of the chapter should be covered in at least two lectures, giving the students  time to absorb the basic ideas. If students have not been previously exposed to probability, expected value, and variance, they  will have difficulty with this chapter, particularly with Exercises (1) through (5), which illustrate  these concepts.  Most students without a background in probability consider risk to be the possibility  of loss or injury, instead of the probability of either loss or gain.  Make sure they understand this  distinction before further discussing uncertainty. If students have had basic probability theory before and you have covered utility theory, they  should easily grasp the definition of expected utility.  However, they usually confuse the utility of an   expected value with expected utility .  Both concepts are needed to explain risk aversion in general and  the subtleties of Exercise (7) in particular.   For an empirical analysis of gambling, see Selby and  Beranek,   “Sweepstake   Contests:   Analysis,   Strategies,   and   Survey,”   American   Economic   Review  (March 1981) and Brunk, “A Test of the Friedman-Savage Gambling Model,”   Quarterly Journal of  Economics   (May 1981).   In a more theoretical class, present the derivation of the Von Neumann- Morgenstern   utility   function.     See   Copeland   and   Weston’s   discussion   of   utility   theory   under  uncertainty in Chapter 4,  Financial Theory and Corporate Policy  (Addison-Wesley, 1979). Even   if   your   students   have   not   fully   understood   the   technical   aspects   of   choice   under  uncertainty,  they  should easily  comprehend  Examples  5.1 and 5.2 (the  latter  example  leads  to  Exercise (8), which is easier than it looks).  This is also true of the topics presented in Section 5.3, i.e.,  diversification and purchasing insurance and Examples 5.3 and 5.4.   Also, you might mention the  problems of adverse selection and moral hazard in insurance, to be discussed in Chapter 17.
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