1. Lectures in Microeconomics-Charles W. Upton Uncertainty ?

2. Our Typical Problem A consumer has income of I Choose between spending on x 1 and x 2 Prices are certain: p 1 and p 2

3. Uncertainty Life is Uncertain I must choose –Whether to buy insurance –Between my current job and another job with an uncertain future. In short, many economic choices involve uncertainty.

4. Uncertainty The Choice $150,000

5. Uncertainty The Choice $150,000 $200,000 $100,000 50%

6. Uncertainty The Choice $150,000 $200,000 $100,000 50% A

7. Uncertainty The Choice $150,000 $200,000 $100,000 50% A B

8. Uncertainty Von Neumann-Morgenstern John von Neumann Oscar Morgenstern

9. Uncertainty The Economics of Uncertainty Utility is a function of income. The higher the level of income, the higher the level of utility.

10. Uncertainty The Economics of Uncertainty Utility is a function of income. The higher the level of income, the higher the level of utility. Decisions are based on expected utility, not expected income.

11. Uncertainty The Choice $150,000 $200,000 $100,000 50% A B U($150,000)

12. Uncertainty The Choice $150,000 $200,000 $100,000 50% A B 0.5U($200,000) + 0.5U($100,000) U($150,000)

13. Uncertainty The Economics of Uncertainty

14. Uncertainty The Economics of Uncertainty Don’t flip

15. Uncertainty The Economics of Uncertainty

16. Uncertainty The Economics of Uncertainty Flip!

17. Uncertainty The Difference U($200,000)> U($150,000)> U($100,000)

18. Uncertainty The Difference U($200,000)> U($150,000)> U($100,000) U($200,000) = 30 U($150,000) = 24 U($100,000) = 17

19. Uncertainty The Difference U($200,000)> U($150,000)> U($100,000) U($200,000) = 30 U($150,000) = 24 U($100,000) = 17 H = U 2

20. Uncertainty The Difference U($200,000)> U($150,000)> U($100,000) U($200,000) = 30 U($150,000) = 24 U($100,000) = 17 H = U 2 H($200,000) = 900 H($150,000) = 576 H($100,000) = 289

21. Uncertainty The Difference U($200,000)> U($150,000)> U($100,000) U($200,000) = 30 U($150,000) = 24 U($100,000) = 17 H = U 2 H($200,000) = 900 H($150,000) = 576 H($100,000) = 289 900>576>289

22. Uncertainty The Difference U($200,000)> U($150,000)> U($100,000) U($200,000) = 30 U($150,000) = 24 U($100,000) = 17 H = U 2 H($200,000) = 900 H($150,000) = 576 H($100,000) = 289 900>576>289

23. Uncertainty Utility is Ordinal H = aU +b I can add a constant and multiply by a constant. Period.

24. Uncertainty Acceptable Transformations U($200,000) = 30 U($150,000) = 24 U($100,000) = 17 H = 2U+ 5 H($200,000) = 65 H($150,000) = 53 H($100,000) = 39

25. Uncertainty Acceptable Transformations U($200,000) = 30 U($150,000) = 24 U($100,000) = 17 H = 2U+ 5 H($200,000) = 65 H($150,000) = 53 H($100,000) = 39 6 7 12 14

26. Uncertainty Acceptable Transformations U($200,000) = 30 U($150,000) = 24 U($100,000) = 17 H = 2U+ 5 H($200,000) = 65 H($150,000) = 53 H($100,000) = 39 6 7 12 14 6<7 Marginal Utility Declines

27. Uncertainty Acceptable Transformations U($200,000) = 30 U($150,000) = 24 U($100,000) = 17 H = 2U+ 5 H($200,000) = 65 H($150,000) = 53 H($100,000) = 39 6 7 12 14 6<7 Marginal Utility Declines 12<14 Marginal Utility Declines

28. Uncertainty Income and Utility U Rises less than proportionally: MU Declining I

29. Uncertainty Income and Utility U I Rises less than proportionally: MU Declining Rises in proportion MU Constant U I

30. Uncertainty Income and Utility U I Rises more than proportionally: MU Increasing U U II Rises less than proportionally: MU Declining Rises in proportion MU Constant

31. Uncertainty And Of Course…

32. Uncertainty End ©2003 Charles W. Upton