Lecture 5 Consumer Choice under uncertainty. Simple lottery: A simple lottery L is a list L=(p1…pn) with pn 0 for all n and , where pn is the probability of the outcome n occurring We can define more complex lotteries (lotteries over lotteries) Compound lottery:
Compound lottery A:
L1=(100,0,0) occurs with probability 1/3
L2=(100*1/4, 100* 3/8, 100*3/8) with probability 1/3
L3=(=(100*1/4, 100*3/8, 100*3/8) with probability 1/3
Compound lottery B:
L1=(100*1/2, 100*1/2, 0) with probability ½
L2=(100*1/2, 0, 100*1/2) with probability ½
Do you prefer A or B?
Since the consumer only cares about the distribution of final outcomes, he will be indifferent between to Compound Lotteries that deliver the same Reduced Lottery
Do you agree?
Concave utility function
Consider the following gamble
Do you accept this gamble?
Consider now these alternative gambles:
Which bet will you be willing to accept?
Source : M. Rabin and R.H.Thaler (2001), Anomalies- Risk Aversion, Journal of Economic Perspectives, pages 219-232