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L11

Explore labor and intertemporal choices, insurance, and consumption across two states of the world, diving into risk attitudes and fair insurance premiums in this informative text. Discover how uncertainty impacts decision-making and happiness.

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L11

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  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

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