SL354, Intermediate Microeconomics Monday Tuesday Thursday Friday Week 1 : March 3 – 7 Introduction Varian, 1 Budget Constraints Varian, 2 Preferences Varian, 3 Utility Varian, 4 Week 2 : March 10 – 14 Choice Varian, 5 Consumer Demand Varian, 6 [7] S. & I. Effects Varian, 8 Problem Set 1 Thaler, 1 – 3 Week 3 : March 17 – 21 Exam 1 Buying & Selling Varian, 9 Buying & Selling Varian, 9 Intertemporal Choice Varian, 10; Thaler, 8 – 9 Week 4 : March 24 – 28 Market Demand Varian, 15 Equilibrium Varian, 16 Problem Set 2 Exam 2 Week 5 : April 7 – 11 Asset Markets Varian, 11 Uncertainty (Risk) Varian, 12 Risky Assets Varian, 13 Portfolio Theory TBD Week 6 : April 14 – 18 Loss Aversion, etc. Thaler, 6 – 7 Capital Markets I Thaler, 10 – 11 Capital Markets II Thaler, 12 and 14 Problem Set 3 Week 7 : April 21 – 25 Exam 3 Technology Varian, 18 Profit Maximization Varian, 19 Exchange Varian, 31 Week 8 : April 28 – May 2 Production Varian, 32 Welfare Varian, 33 General Equilibrium TBD Problem Set 4 Week 9 : May 5 – 9 Exam 4 Auctions Varian, 17 Auctions Thaler, 5 Externalities Varian, 34 Week 10 : May 12 – 16 Information Varian, 35 Asymmetric Information Varian, 37 Problem Set 5 Thaler, 15 Exam 5

Intertemporal Trades • • Borrowing in period 1

Intertemporal Trades Patient preferences Impatient preferences (Negative time preference) Impatient preferences (Positive time preference)

Asset Markets: Debt

Asset Markets: Debt

Asset Markets: Equity

Asset Markets: Equity GE Average 1982-2005 24% SP500 Average 1982-2005 12.3% *Calculated from a value-weighted index of all publicly traded stocks using CRSP data. *Calculated as compounded annual return on average monthly returns from preceding 12 months.

Present Valuation Techniques and Asset Valuation The present value (PV) of an amount to be received at time t (FV) when the per-period discount rate is r: The present value (PV) of a stream of future values, when the per-period discount rate is r: Bond pricing. The price of a bond will be the net present value of interest payments and the maturity date and value. Stock valuation. The current value of a firm (PVFirm) is the present value of the stream of future profits that the firm will generate -- and shareholders are “residual claimants” of those profits:

Optimal Holding Period for an Asset Rate of return from holding asset t*

Risk and Uncertainty: “Contingent Consumption Plans” Case 2: A person with an endowment of $35,000 faces a 1% probability of losing $10,000. He is considering the purchase of full insurance against the loss for $100. Case 1: A person with an endowment of $100 is considering the purchase of a lottery ticket that costs $5. The winning ticket in the lottery gets $200. $100 Outcome A: Outcome B: If Pr(Lucky) = 0.025): $35,000 Lucky day Do not purchase Do not purchase Unlucky day $25,000 Lucky day Lucky day $295 $34,900 Purchase Purchase Unlucky day Unlucky day $95 $34,900

Risk and Uncertainty: “Contingent Consumption Plans” $35,000 Lucky day Do not purchase Unlucky day $25,000 Lucky day $34,900 • Purchase Unlucky day $34,900 • K = the “expected loss” ($10,000), and gK is the insurance premium.

The Meaning of Risk Aversion Economic Treatment of Risk The Meaning of Risk Aversion 1. Risk aversion is defined through peoples’ choices: 2. Non-linearity in the utility of wealth. Given a choice between two options with equal expected values and different standard deviations, a risk averse person will choose the option with the lower standard deviation: Given a choice between two options with equal standard deviations and different expected values, a risk-averse person will choose the option with the higher expected value:

Dealing With Risk: Insurance $100,000 Pr(xA) = .990 E[X] = $99,500 s = $4,975 cv = 0.0500 Pr(xB) = .010 $50,000

Dealing With Risk: Insurance $100,000 - $500 $99,500 Pr(xA) = .990 E[X] = $99,500 s = $0 cv = 0 $100,000 Pr(xB) = .010 $100,000 $500 - $50,000 + $50,000 $99,500

Dealing With Risk: Insurance For a risk-averse person . . . Is Preferable to E[X] = $99,500 s = $0 cv = 0 E[X] = $99,500 s = $4,975 cv = 0.0500 Can we find another option, keeping s = $0, but with a lower E[X], that will be considered equal to the original? For example, suppose that for this risk-averse person . . . Is Equivalent to E[X] = $99,415 s = $0 cv = 0 E[X] = $99,500 s = $4,975 cv = 0.0500

Dealing With Risk: Insurance If, for a risk-averse person . . . Is Equivalent to E[X] = $99,500 s = $4,975 cv = 0.0500 $99,415 Then $99,415 is called a certainty equivalent. Furthermore, we will be able to sell an insurance policy to this person for $585. The $85 difference between the amount the person will pay and the expected loss is called a risk premium.

The Meaning of Risk Aversion Economic Treatment of Risk Utility The Meaning of Risk Aversion A U($) U3 l U2 l l B D U1 l C Risk Premium $ $0 $99,415 $99,500 $100,000 $50,000

Risk Aversion and Risk Neutrality Economic Treatment of Risk Utility U($) Risk Aversion and Risk Neutrality U($) U($) Risk Aversion Risk Neutral Risk Seeking $

Economic Treatment of Risk Utility Risk Tolerance U1($) U2($) Risk Premium 1 Risk Premium 2 $ Risk Premium 1 > Risk Premium 2 : Agent 1 is more risk averse than Agent 2 Agent 2 is more risk tolerant than Agent 1

Certainty Equivalent: Modeling Risk and Expected Utility in Insurance Problems Expected Utility: Certainty Equivalent: Risk Premium:

Dealing With Risk: Diversification (Portfolio Theory) Expected Return of a Portfolio (2 investments): Expected Variance of a Portfolio (2 investments):

Dealing With Risk: Diversification (Portfolio Theory) Portfolio Example

Capital Asset Pricing Model Capital Market Line Security Market Line 1

Capital Asset Pricing Model 3-Year 5-Year 10-Year Mutual Fund Name Symbol Beta Returns American Century Heritage A ATHAX 1.44 20.50 1.17 19.26 0.96 8.42 Fidelity Advisor Equity Growth T FAEGX 1.18 8.31 1.16 11.20 3.34 Fidelity Magellan FMAGX 1.33 6.88 1.03 10.42 1.04 3.53 Putnam International Growth & Income PNGAX 1.07 12.55 20.56 6.90 Fidelity Diversified International FDIVX 1.08 14.57 1.02 22.18 10.85 Templeton Growth A TEPLX 0.77 5.78 0.85 14.81 0.80 7.01 Vanguard 500 Index VFINX 1.00 5.72 11.18 3.43 Vanguard Total Stock Market Index VTSMX 6.19 12.27 1.01 3.89 Vanguard PRIMECAP VPMCX 9.63 1.06 15.78 8.50 Janis Growth & Income JAGIX 1.13 6.69 1.05 11.22 0.98 5.84 Dreyfus Premier Balanced B PRBBX 4.05 0.90 6.59 0.87 1.43 Dreyfus Founders Balanced A FRIDX 3.71 0.88 7.21

Capital Asset Pricing Model Name Symbol Beta Aetna AET 1.08 Anheuser Busch BUD 0.60 Bank of America BAC 0.32 Boeing BA 0.88 Cummins Inc. CMI 1.35 Deere & Co. DELL 1.23 Dell 1.81 Eli Lilly Co. LLY 0.43 Family Dollar Stores FDO 0.82 General Electric GE 0.70 General Motors GM 1.27 Google GOOG 2.01 Intel INTC 1.72 J.P. Morgan Chase JPM 0.68 Microsoft MSFT 1.61 Nordstrom Inc. JWN 1.51 Pfizer PF 0.75 Wal-Mart Stores WMT -0.18 Wellpoint Inc. WLP 0.61 Wells Fargo WFC

Economic Analysis of Market Opportunities Efficient Markets and Economic Profits – Total Market Returns, Selected Time Periods

Loss Aversion You are offered the following bet: A coin will be tossed. If it is heads you win x; if it is tails, you lose y. + (Gain) + (Loss) + v - v + $30 - $10 Value = V($) “Most respondents in a sample of undergraduates refused to stake $10 on the toss of a coin if they stood to win less than $30.”