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Slide_05 - ECO1011B Basic Micro th set of slides 5 Travis...

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ECO1011B Basic Micro 5 th set of slides Travis Ng 2008 Fall
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Behavior under uncertainty " Life was like a box of chocolates. You never know what you're gonna get." -- Forrest Gump
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Behavior under uncertainty “But whether you are successful depends on whether you pick the right boxes of chocolates!” -- A quote that they may have never made.
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Behavior under uncertainty When do you ever make decision that does NOT involve uncertainty? Your ECO1011B partner, your lover, the University program you applied, Election on Sep 7, your pet, etc.
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Goal To have a coherent framework in understanding human behaviors under uncertainty.
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Principles carried over We are rational. Faced with uncertainty, we strive for the best possible actions to maximize happiness. Action: choosing the best possible BOX OF CHOCOLATE to make us as happy as possible. Cost-benefits analysis is still a useful tool for analysis, provided it is augmented carefully with uncertainty. Opportunity cost is still one of the main ideas for analysis.
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We hate uncertainty Everything else equal, we like things to be more certain. physical fitness, weight, amount in your bank account, relationship, etc.
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Implication We don’t like to take risk. But if we do, the reward must have been big ENOUGH.
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Workhorses A reasonable measure of happiness that incorporates people’s preferences towards uncertainty. A reasonable measure of uncertainty.
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Workhorses Expected utility Probability distribution of outcomes
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Workhorses Expected utility Probability distribution of outcomes Peter’s Utility function = U( outcome i ) = Peter’s level of happiness if outcome i happens. Happiness = Expected Utility = p 1 U( outcome 1 ) + p 2 U( outcome 2 ) + p 3 U( outcome 3 ) + ……. ., where p 1 is the probability that outcome i happens.
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Workhorses Peter chooses the lottery that maximizes his “happiness under uncertainty”, i.e., his expected utility E.g., Whether he should marry Miss A, or Miss B. Peter’s Expected Utility from marrying Miss A: E A (U) = p A 1 U( outcome A 1 ) + p A 2 U( outcome A 2 ) + p A 3 U( outcome A 3 ) + ……. ., Peter’s Expected Utility from marrying Miss B: E B (U) = p B j U( outcome B j ) + p B k U( outcome B k ) + p B l U( outcome B l ) + ……. .,
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Measure Risk We start with the measure of risk. To take a trip to Mexico city, you expect to have fun for 80% of the chance. You expect to bump into terrible people and be unhappy for 19% of the chance. You expect to bump into accident and die for 1% of the chance. With these information, how can you figure out a reasonable measure of risk?
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To buy Google, you expect to have 40% return for 80% of the chance. You expect the economy to go into a recession and your investment loses 40% of value for 19% of the chance. You expect to Google to go broke and you lose all your investment for 1% of the chance. With these information, how can you figure
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Slide_05 - ECO1011B Basic Micro th set of slides 5 Travis...

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