1. L11
Uncertainty

2. Three Applications 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)

3. Uncertainty Two States of the world: no rain and rain Probabilities
Goods: wealth
Endowment: wealth in two states
New:
No markets for but insurance
Consumption bundle = lottery

4. Insurance contract Insurance contract Premium insurers choice
Coverage consumer’s choice
Timing:

5. Uncertainty and Lotteries

6. Budget Constraint

7. Translation: (“as if” markets)

8. Expected value Lottery (random variable)
Expected value: average payment
Examples

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

10. 3 Risk attitudes (aversion)
Example
Lottery
D:Risk aversion:
Risk neutrality Risk loving

11. Risk attitudes
Example 1:
Example 2:
Example 3:

12. Indifference curves

13. Marginal Rate of Substitution

14. Choice of Insurance

15. Magic formulas

16. Fair vs. not fair Insurance
Fair premium
Not fair premium
Why? Expected profit of insurer
Free Entry drives profit to zero

17. Fair premium = full insurance

18. Partial Insurance
First secret of happiness