Ch05_1 - Chapter 5: Uncertainty and Consumer Behavior...

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Unformatted text preview: 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 Westons 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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Ch05_1 - Chapter 5: Uncertainty and Consumer Behavior...

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