Topic13_Uncertainty

Topic13_Uncertainty - Uncertainty and Uncertainty and...

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Topic 13 ncertainty and Uncertainty and ehavioral Economics Behavioral Economics COMM 295 Ratna K. Shrestha
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Introduction nlike the choice under certainty choice Unlike the choice under certainty, choice under uncertainty is risky and so is difficult to ake. make. How do we make choices when certain variables such as income and prices are uncertain? Examples: Which products to bring to market? Which stocks to invest in? 2
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troduction Introduction 3
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easuring and Describing Risk Measuring and Describing Risk o easure sk we must know: To measure risk we must know: 1. All of the possible outcomes. 2. The probability or likelihood that each outcome will occur. Two measures to help describe and compare risky choices are: 1. Expected value 2. Variability 4 y
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Describing Risk xpected Value Expected Value The weighted average of the payoffs or values resulting from all possible outcomes. In general, for n possible outcomes: Possible outcomes having payoffs X1, X2, … Xn Probability of each outcome is P 1 , P 2 , … P n . n n 2 2 1 1 X ... X P X P E(X) P 5
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Expected Value: Example hat is the expected value of the What is the expected value of the following random income? rob (p) income ) Prob. (p) income (X) 0.3 $100 0.2 $200 0.1 $1000 0.4 $500 E(X) = p x + p x +…. . = $370 6 1 1 2 2
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Describing Risk ariability: ariability comes from Variability: Variability comes from deviations in actual payoffs relative to the expected payoff. Greater variability of actual payoffs from expected values signals greater risk. Variance or Standard Deviation measures variability. Variance ... )) ( ( )) ( ( 2 2 2 2 1 1 2 x E x p x E x p 7
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Variability tandard Deviation is the square root of Standard Deviation is the square root of Varaince . xample Example : Assume Job 1 with 0.5 probability of making either $15 or $5. E(X) = 0.5*15+0.5*5 = $10 Assume Job 2 with 0.6 probability of making $20 and 0.40 probability of losing $5. E(X) = 0.6*20+0.4*(-5) = $10 8
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Variability – An Example Expected incomes of both the jobs E(X) = $10. Outcome x1 Deviation from E(x) Outcome x2 Deviation From E(x) Job 1 $15 $5 $5 -$5 Job 2 $20 $10 $5 -$5 9
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ariance xample Variance– Example ariance of the two jobs are: Variance of the two jobs are: 25 ) 10 5 ( * 5 . 0 ) 10 15 ( * 5 . 0 2 2 2 1 70 25 * 4 . 0 100 * 6 . 0 2 2 Job 2 has a larger variance than job 1 and so it is the riskier alternative. In this case when both jobs have equal E(X) but one is riskier than the other, decision aking is fairly easy 10 making is fairly easy.
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Decision Making under Uncertainty ow consider Now consider Job 1 : with expected income $ 20 and ariance of $40. variance of $40. Job 2 : with expected income of $30 and variance of $ 80. Which job should be chosen? ome may be willing to take risk with Some may be willing to take risk with higher expected income. Others prefer less risk even with lower expected 11 income.
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Expected Utility o which one will you choose depends on So which one will you choose depends on your attitude towards risk as reflected in our tility function
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Topic13_Uncertainty - Uncertainty and Uncertainty and...

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