Lecture02-2004 - Von Neumann-Morgenstern and Lecture II I....

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1 Von Neumann-Morgenstern and Lecture II I. Utility and different views of risk A. Knightian – Frank Knight 1. Risk – known probabilities of events 2. Uncertainty – unknown or unknowable probabilities B. Von Neumann – Morgenstern 1. Axiomatic treatment 2. Consumers maximize expected utility C. Savage 1. Consumers maximize subjective utility D. Arrow – Debreu 1. State – preference securities II. Numerical Stuff A. In the preceding lecture, we found the expected utility of a gamble that paid $150,000 with probability of .6 and $50,000 with probability .4. Assuming a 0.5 r = , the power utility function yields a certainty equivalent of $103,569. B. Let’s work on a slightly different problem; again assume that we have a risky gamble that pays $150,000 with some probability p and $50,000 with probability () 1 p . 1. I assert that we can find a p that makes the decision maker indifferent between the risky gamble and a certain payoff of $108,000. Naturally, we assume that p is higher than .6 (why?).
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This note was uploaded on 07/15/2011 for the course AEB 6145 taught by Professor Moss during the Spring '11 term at University of Florida.

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Lecture02-2004 - Von Neumann-Morgenstern and Lecture II I....

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