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L11 Uncertainty.

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Presentation on theme: "L11 Uncertainty."— Presentation transcript:

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: consumption Endowment: wealth in two states Possibility of insurance

4 Budget Constraint

5 Uncertainty and Lotteries

6 Translation: (“as if” markets)

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

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

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

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

11 Indifference curves

12 Marginal Rate of Substitution

13 Choice of Insurance

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

15 Fair Insurance

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

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