6F9B3196 - Chapter Twelve Uncertainty Uncertainty is...

Info icon This preview shows pages 1–19. Sign up to view the full content.

View Full Document Right Arrow Icon
Chapter Twelve Uncertainty
Image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Uncertainty is Pervasive What is uncertain in economic systems? tomorrow’s prices future wealth future availability of commodities present and future actions of other people.
Image of page 2
Uncertainty is Pervasive What are rational responses to uncertainty? buying insurance (health, life, auto) a portfolio of contingent consumption goods.
Image of page 3

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
States of Nature Possible states of Nature: “car accident” (a) “no car accident” (na). Accident occurs with probability π a , does not with probability π na ; π a + π na = 1. Accident causes a loss of $L.
Image of page 4
Contingencies A contract implemented only when a particular state of Nature occurs is state- contingent. E.g. the insurer pays only if there is an accident.
Image of page 5

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Contingencies A state-contingent consumption plan is implemented only when a particular state of Nature occurs. E.g. take a vacation only if there is no accident.
Image of page 6
State-Contingent Budget Constraints Each $1 of accident insurance costs γ . Consumer has $m of wealth. • C na is consumption value in the no- accident state. • C a is consumption value in the accident state.
Image of page 7

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
State-Contingent Budget Constraints C na C a 20 17 A state-contingent consumption with $17 consumption value in the accident state and $20 consumption value in the no-accident state.
Image of page 8
State-Contingent Budget Constraints Without insurance, • C a = m - L • C na = m.
Image of page 9

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
State-Contingent Budget Constraints C na C a m The endowment bundle. m L -
Image of page 10
State-Contingent Budget Constraints Buy $K of accident insurance. • C na = m - γ K. • C a = m - L - γ K + K = m - L + (1- γ )K.
Image of page 11

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
State-Contingent Budget Constraints Buy $K of accident insurance. • C na = m - γ K. • C a = m - L - γ K + K = m - L + (1- γ )K. So K = (C a - m + L)/(1- γ ) And C na = m - γ (C a - m + L)/(1- γ ) I.e. C m L C na a = - - - - γ γ γ γ 1 1
Image of page 12
State-Contingent Budget Constraints C na C a m The endowment bundle. Where is the most preferred state-contingent consumption plan? C m L C na a = - - - - γ γ γ γ 1 1 slope = - - γ γ 1 m L - γ γ m L -
Image of page 13

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Preferences Under Uncertainty Think of a lottery. Win $90 with probability 1/2 and win $0 with probability 1/2. U($90), U($0). Expected utility is EU=1/2*U($90)+1/2*U(0)
Image of page 14
Preferences Under Uncertainty Think of a lottery. Win $90 with probability 1/2 and win $0 with probability 1/2. Expected money value of the lottery is EM $90 $0 = × + × = 1 2 1 2 45 $ .
Image of page 15

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Preferences Under Uncertainty EU and EM = $45. U($45) > EU $45 for sure is preferred to the lottery risk-aversion. U($45) < EU the lottery is preferred to $45 for sure risk-loving. U($45) = EU the lottery is preferred equally to $45 for sure risk-neutrality.
Image of page 16
Preferences Under Uncertainty Wealth $0 $90 12 U($45) U($45) > EU risk-aversion. 2 EU $45 MU declines as wealth rises.
Image of page 17

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Preferences Under Uncertainty Wealth $0 $90 12 U($45) < EU risk-loving.
Image of page 18
Image of page 19
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern