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

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Presentation on theme: "L12 Uncertainty. Model with real endowments 1. Labor Supply (Labor-Leisure Choice) 2. Intertemporal Choice (Consumption-Savings Choice) 3. Uncertainty."— Presentation transcript:

1 L12 Uncertainty

2 Model with real endowments 1. Labor Supply (Labor-Leisure Choice) 2. Intertemporal Choice (Consumption-Savings Choice) 3. Uncertainty (Insurance) (Consumption across states of the world) Three Applications

3 Uncertainty u Two States of the world: no rain and rain u Probabilities u Goods: consumption u Endowment: wealth in two states u Possibility of insurance

4 Budget Constraint

5 Uncertainty and Lotteries

6 Translation: (“as if” markets)

7 Expected value u Lottery (random variable) u Expected value: average payment u Examples

8 Preferences and Utility u Uncertainty – special preferences u Bernoulli utility function u Von Neumann-Morgenstern utility (Expected utility)

9 Risk aversion u Risk averse, Risk Loving, Risk neutral u Lottery u Risk aversion: better than

10 Risk attitudes u Example 1: u Example 2: u Example 3:

11 Indifference curves

12 Marginal Rate of Substitution

13 Choice of Insurance

14 Fair vs. not fair Insurance u Fair Insurance u Not fair insurance u Why? u Free Entry and Law of Large Numbers

15 Fair Insurance

16 Not Fair Insurance When Insurance is not fair u In optimum: (First secret of happiness)

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