slide2-decision-making-under-uncertainty

slide2-decision-making-under-uncertainty - Decision Making...

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Decision Making Under Uncertainty Professor Erkut Ozbay Economics 300

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Uncertainty Consumers and firms are usually uncertain about the payoffs from their choices Example 1: A farmer chooses to cultivate either apples or pears When he makes the decision, he is uncertain about the profits that he will obtain. He does not know which is the best choice This will depend on rain conditions, world prices…
Uncertainty Example 2: playing with a fair die You win \$2 if 1, 2, or 3, You neither win nor lose if 4, or 5 You lose \$6 if 6 Example 3: John’s monthly consumption: \$3000 if he does not get ill \$500 if he gets ill (so he cannot work)

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Vocabulary A lottery is a situation which involves uncertain payoffs: Cultivating apples Cultivating pears Playing with a fair die Monthly consumption Each lottery results in a prize
Introduction to Random Variables Let’s play a game (in theory): To play the game, you must pay \$5 to select a card from a standard deck. If the card you select is the ace of hearts, you will win \$100. For any other ace, you will win \$10 and for any other heart, you win \$5. Is anyone willing to play this game?

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Possible Outcomes and Corresponding Probabilities Net Payoff Probability \$95 1/52 \$5 3/52 \$0 12/52 -5 36/52 What can you expect to win if you were to play this game? A Other Ace Other Otherwise
Possible Outcomes and Corresponding Probabilities Net Payoff Probability \$95 1/52 \$5 3/52 \$0 12/52 -5 36/52 What can you expect to win if you were to play this game? 1 3 12 36 ( ) 95 5 0 ( 5) \$1.35 52 52 52 52 E X         = + + + - = -  ÷  ÷  ÷  ÷         A Other Ace Other Otherwise

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Random Variables A random variable , X, is a quantitative variable that has values that vary according to the rules of probability. Elements of the sample space are all the possible values
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This note was uploaded on 12/04/2011 for the course ECON 300 taught by Professor Cramton during the Fall '08 term at Maryland.

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slide2-decision-making-under-uncertainty - Decision Making...

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