Chapter Twelve Uncertainty. Uncertainty is Pervasive u What is uncertain in economic systems? –tomorrow’s prices –future wealth –future availability of.

Slides:

Advertisements

Similar presentations

Hal Varian Intermediate Microeconomics Chapter Thirteen

Advertisements

Choice under Uncertainty. Introduction Many choices made by consumers take place under conditions of uncertainty Therefore involves an element of risk.

Chapter 12 Uncertainty Consider two lotteries L 1 : 500,000 (1) L 1 ’: 2,500,000 (0.1), 500,000 (0.89), 0 (0.01) Which one would you choose? Another two.

Choices Involving Risk

1 . 2 Uncertainty Dixit: Optimization in Economic Theory (Chapter 9)

Risky Choices and Risk Aversion

Chapter Eleven Asset Markets. Assets u An asset is a commodity that provides a flow of services over time. u E.g. a house, or a computer. u A financial.

Risk Valuation First, we need to identify the risks Second, we need to value the risks To do that, we need to KNOW the losses AND the probabilities with.

Decision-Making under Uncertainty – Part I Topic 4.

Economics 202: Intermediate Microeconomic Theory 1.HW #5 on website. Due Tuesday.

The Economics of Information. Risk a situation in which there is a probability that an event will occur. People tend to prefer greater certainty and less.

Risk a situation in which there is a probability that an event will occur. People tend to prefer greater certainty and less risk.

Interactions of Tax and Nontax Costs n Uncertainty u Symmetric uncertainty u Strategic uncertainty (information asymmetry) F Hidden action (moral hazard)

1 Utility Examples Scott Matthews Courses: /

317_L13, Feb 5, 2008, J. Schaafsma 1 Review of the Last Lecture finished our discussion of the demand for healthcare today begin our discussion of market.

Uncertainty and Information CHAPTER 19. After studying this chapter you will be able to Explain how people make decisions when they are uncertain about.

Uncertainty and Consumer Behavior

Chapter 9 THE ECONOMICS OF INFORMATION Copyright ©2002 by South-Western, a division of Thomson Learning. All rights reserved. MICROECONOMIC THEORY BASIC.

Copyright © 2004 South-Western 27 The Basic Tools of Finance.

Chapter Twelve Uncertainty. Uncertainty is Pervasive u What is uncertain in economic systems? –tomorrow’s prices –future wealth –future availability of.

Chapter Eleven Asset Markets. Assets u An asset is a commodity that provides a flow of services over time. u E.g. a house, or a computer. u A financial.

Chapter Eleven Asset Markets. Assets u An asset is a commodity that provides a flow of services over time. u E.g. a house, or a computer. u A financial.

The Basic Tools of Finance

Chapter Twelve Uncertainty. Uncertainty is Pervasive u What is uncertain in economic systems? –tomorrow’s prices –future wealth –future availability of.

Lectures in Microeconomics-Charles W. Upton Uncertainty ?

SL354, Intermediate Microeconomics

The Basic Tools of Finance

Basic Tools of Finance Finance is the field that studies how people make decisions regarding the allocation of resources over time and the handling of.

Full Insurance Theorem Risks to Wealth. Motives  Practical risk management  Analysis: base case  First example of general principles.

EXPECTED UTILITY AND RISK AVERSION

Lecture 3: Arrow-Debreu Economy

Steven Landsburg, University of Rochester Chapter 18 Risk and Uncertainty Copyright ©2005 by Thomson South-Western, a part of the Thomson Corporation.

Decision-making under uncertainty. Introduction Definition of risk Attitudes toward risk Avoiding risk: Diversification Insurance.

Chapter 16 Uncertainty We must believe in luck. For how else can we explain the success of those we don’t like? Jean Cocteau.

Microeconomics Corso E John Hey. Chapters 23, 24 and 25 CHOICE UNDER RISK Chapter 23: The Budget Constraint. Chapter 24: The Expected Utility Model. Chapter.

Copyright © 2004 South-Western 27 The Basic Tools of Finance.

Chapter 5 Uncertainty and Consumer Behavior. ©2005 Pearson Education, Inc.Chapter 52 Q: Value of Stock Investment in offshore drilling exploration: Two.

Stephen G. CECCHETTI Kermit L. SCHOENHOLTZ Understanding Risk Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

Chapter 5 Choice Under Uncertainty. Chapter 5Slide 2 Topics to be Discussed Describing Risk Preferences Toward Risk Reducing Risk The Demand for Risky.

B ASIC T OOLS OF F INANCE ETP Economics 102 Jack Wu.

1 Chapter 18 UNCERTAINTY AND RISK AVERSION. 2 Probability The probability of a repetitive event happening is the relative frequency with which it will.

Midterm 2 Review. Midterm 2 (L9-L16)  Applications of buying and selling 1.Labor Supply 2.Intertemporal Choice 3.Uncertainty  Markets and Exchange 1.Pareto.

Uncertainty. u What is uncertain in economic systems? –tomorrow’s prices –future wealth –future availability of commodities –present and future actions.

Decision theory under uncertainty

© 2010 W. W. Norton & Company, Inc. 12 Uncertainty.

The Economics of Information and Choice Under Uncertainty.

What is ‘Managed Care’? A ‘type’ of health insurance –combines both the financing of care (insurance) with the provision of care –variations in MC plans.

Uncertainty and Consumer Behavior Chapter 5. Uncertainty and Consumer Behavior 1.In order to compare the riskiness of alternative choices, we need to.

Chapter Seventeen Uncertainty. © 2009 Pearson Addison-Wesley. All rights reserved Topics  Degree of Risk.  Decision Making Under Uncertainty.

Copyright © 2004 South-Western 27 The Basic Tools of Finance.

5-1 Economics: Theory Through Applications. 5-2 This work is licensed under the Creative Commons Attribution-Noncommercial-Share Alike 3.0 Unported License.

1 The economics of insurance demand and portfolio choice Lecture 1 Christian Gollier.

Managerial Economics Uncertainty Aalto University School of Science Department of Industrial Engineering and Management January 12 – 28, 2016 Dr. Arto.

Microeconomics Course E John Hey. Chapter 26 Because we are all enjoying risk so much, I have decided not to cover Chapter 26 (on the labour market)

MTH 105. FINANCIAL MARKETS What is a Financial market: - A financial market is a mechanism that allows people to trade financial security. Transactions.

Money and Banking Lecture 11. Review of the Previous Lecture Application of Present Value Concept Internal Rate of Return Bond Pricing Real Vs Nominal.

Chapter 12 Uncertainty 1. Uncertainty is Pervasive  What is uncertainty in economic systems?  tomorrow’s prices  future wealth  future availability.

L12 Uncertainty. Model with real endowments 1. Labor Supply (Labor-Leisure Choice) 2. Intertemporal Choice (Consumption-Savings Choice) 3. Uncertainty.

Chapter 5 Understanding Risk

L11 Uncertainty.

Microeconomics 2 John Hey.

12 Uncertainty.

Chapter Five Understanding Risk.

L11 Uncertainty.

Buying and Selling: Uncertainty

L12 Uncertainty.

Chapter Twelve Uncertainty.

Buying and Selling: Uncertainty

Chapter 12 Uncertainty.

Buying and Selling: Uncertainty

Presentation transcript:

Chapter Twelve Uncertainty

Uncertainty is Pervasive u What is uncertain in economic systems? –tomorrow’s prices –future wealth –future availability of commodities –present and future actions of other people.

Uncertainty is Pervasive u What are rational responses to uncertainty? –buying insurance (health, life, auto) –a portfolio of contingent consumption goods.

States of Nature u Possible states of Nature: –“car accident” (a) –“no car accident” (na). u Accident occurs with probability  a, does not with probability  na ;  a +  na = 1. u Accident causes a loss of $L.

Contingencies u A contract implemented only when a particular state of Nature occurs is state-contingent. u E.g. the insurer pays only if there is an accident.

Contingencies u A state-contingent consumption plan is implemented only when a particular state of Nature occurs. u E.g. take a vacation only if there is no accident.

Preferences Under Uncertainty u Think of a lottery. Suppose U(x) = x.5 u Win $100 with probability 1/2 and win $0 with probability 1/2. u U($100) = 10, U($0) = 0. u Expected utility is

Preferences Under Uncertainty u Think of a lottery. u Win $90 with probability 1/2 and win $0 with probability 1/2. u Expected money value of the lottery is

Preferences Under Uncertainty Wealth$0$ U($50) U($50) > EU  risk-aversion. EU=5 $50 MU declines as wealth rises.

Preferences Under Uncertainty Wealth $0$ U($50) < EU  risk-loving. Example: U(x) = x 2. EU = U(50) = 2500 EU=5000 $50 MU rises as wealth rises. U($50)

Preferences Under Uncertainty Wealth $0 $ U($50) = EU  risk-neutrality. Example: U(x) = 4x + 5 $50 MU constant as wealth rises. U($50)= EU=205 5

Preferences Under Uncertainty u State-contingent consumption plans that give equal expected utility are equally preferred.

Choice Under Uncertainty u Q: How is a rational choice made under uncertainty? u A: Choose the most preferred affordable state-contingent consumption plan.

Competitive Insurance u Suppose entry to the insurance industry is free. u Expected economic profit = 0. o If price of $1 insurance = accident probability, then insurance is fair. o Even if insurance is ‘unfair’, a risk- averse person might buy some.

Diversification u Two firms, A and B. Shares cost $10. u With prob. 1/2 A’s profit is $100 and B’s profit is $20. u With prob. 1/2 A’s profit is $20 and B’s profit is $100. u You have $100 to invest. How?

Diversification u Buy only firm A’s stock? u $100/10 = 10 shares. u You earn $1000 with prob. 1/2 and $200 with prob. 1/2. u Expected earning: $500 + $100 = $600

Diversification u Buy only firm B’s stock? u $100/10 = 10 shares. u You earn $1000 with prob. 1/2 and $200 with prob. 1/2. u Expected earning: $500 + $100 = $600

Diversification u Buy 5 shares in each firm? u You earn $600 for sure. u Diversification has maintained expected earning and lowered risk. u Typically, diversification lowers expected earnings in exchange for lowered risk.