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

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Presentation transcript:

Uncertainty

u What is uncertain in economic systems? –tomorrow’s prices –future wealth –future availability of commodities –present and future actions of other people. u Rational responses to uncertainty (when the agent is risk-averse): –buying insurance (health, life, auto); –diversification (typically diversification lowers expected earnings in exchange for lowered risk).

Preferences Under Uncertainty u Think of a lottery. u Win €90 with probability 1/2 and win €0 with probability ½ (states of Nature and probabilities). u U(€90) = 12, U(€0) = 2. 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 U(€90) = 12, U(€0) = 2. 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 u EU = 7 and EM = €45 u U(€45) > 7  €45 for sure is preferred to the lottery  risk-aversion (utility of expected value is higher than expected value of utility). u U(€45) < 7  the lottery is preferred to €45 for sure  risk-loving. u U(€45) = 7  the lottery is preferred equally to €45 for sure  risk-neutrality.

Preferences Under Uncertainty Wealth€0€90 12 U(€45) U(€45) > EU  risk-aversion 2 EU=7 €45 MU declines as wealth rises.

Preferences Under Uncertainty Wealth€0€90 12 U(€45) < EU  risk-loving 2 EU=7 €45 MU rises as wealth rises. U(€45)

Preferences Under Uncertainty Wealth€0€90 12 U(€45) = EU  risk-neutrality 2 €45 MU constant as wealth rises. U(€45)= EU=7

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