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Ch. 22 (amended) Uncertainty&amp;Informational Problems

# Ch. 22 (amended) Uncertainty&amp;Informational Problems...

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Three Major Topics Decisions under uncertainty (not in Ch. 22) Asymmetric information Behavioral Economics (Not covering “Political Economy” this semester)
Two Alternatives Alternative A You have wealth of \$135,300. Alternative B 50 percent chance you have wealth of \$270,600. 50 percent chance you have wealth of zero.

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Expected Value Expected value is the average value of an event based on repeating the situation many times. Expected value is calculated by taking every possible outcome, multiplying each possible outcome by the probability that outcome will occur, and then summing the results.
Expected Value Example I roll one die If the number is odd, I pay you the square of the number I roll If the number is even, you pay me the square of the number I roll What is the expected value of your payoff in this game?

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Number Payoff Probability Payoff x Probability 1 1 1/6 1/6 2 -4 1/6 -4/6 3 9 1/6 9/6 4 -16 1/6 -16/6 5 25 1/6 25/6 6 -36 1/6 -36/6 Expected value -21/6
Insurance Example Your house is worth \$40,000 You have \$30,000 in a savings account There is a 10 percent chance of a fire. If the fire occurs there will be \$30,000 of damage to your home. What is expected value of your wealth without property insurance?

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Expected value = (.9 x 70,000) + (.1 x 40,000) = 67,000
Insurance Policy You pay the insurance company a premium of \$3,000 at the start of the year.

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