14_PreferencesOverRisk

# 14_PreferencesOverRisk - History has not dealt kindly with...

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“History has not dealt kindly with the aftermath of protracted periods of low risk premiums.” –Alan Greenspan ECON 410 Preferences over Risk

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2 Class 14 - Preferences Over Risk
3 Inferior Goods An Inferior Good is a good whose Income Effect is in the opposite direction as the Substitution Effect. Normal Goods A Normal Good is a good whose Income Effect is in the same direction as the Substitution Effect. Giffen Goods A Giffen Good is a specific type of Inferior good whose Income Effect is in the opposite direction as the Substitution Effect and exceeds it in magnitude.

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4 Working Leisure I 1 I 3 ICorig xnew BLne w xorig BLcompe xsubs S I
5 Work Leisure xorig ICorig BLn ew xnew xsubs BLcompensated S I

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6 Work Leisure xorig ICorig BLn ew xnew xsubs BLcompensated S I
7 Giffen Goods A Giffen Good is a specific type of Inferior good whose Income Effect is in the opposite direction as the Substitution Effect and exceeds it in magnitude. In other words, |xnew- xsubs|>|xsubs- xorig|.

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Group-Clicker Question (P): Via. our 5-step graphical technique, you have discovered that for a given price change, xorig=6, xnew=8, xsub=10. The good is: 1. Normal 2. Inferior (but not Giffen) 3. Giffen 1 2 3 33% 33% 33%
Group-Clicker Question (P): Via. our 5-step graphical technique, you have discovered that for a given price change, xorig=6, xnew=8, xsub=10. Which of the following statements is true? 1. dx/d I >0 2. dx/d I =0 3. dx/d I <0 1 2 3 33% 33% 33%

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Group-Clicker Question (P): Via. our 5-step graphical technique, you have discovered that for a given price change, xorig=6, xnew=8, xsub=10. Does the Law of Demand hold? 1. Yes, indeed. 2. No 1 2 50% 50%
11 Class 14 - Preferences Over Risk

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12 Class 14 - Preferences Over Risk Expected Utility Theorem If an individual’s preferences over lotteries are complete, transitive, continuous, and satisfy the independence axiom, then (p1, p2,…pn) (q1, q2,…qn) if and only if p1u1+p2u2+…+pnun >= q1u1+q2u2+…+qnun where the ui’s are known as von Neumann-Morgenstern (vNM) utilities and can be interpreted as the cardinal utility received from good i.
13 Class 14 - Preferences Over Risk vNM Utility: 10 Lottery: (.10, .90) Expected Utility = 1 Things: Lottery: vNM Utility: 1 (1,0) Expected Utility = 1

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Class 14 - Preferences Over Risk Expected Utility Theorem 1. Given probabilities and vNM utilities, which lottery is preferred? 2. Given probabilities and a given lottery preference, how high/low must vNM utilities be to be consistent with that preference? 3.
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14_PreferencesOverRisk - History has not dealt kindly with...

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