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Uncertainty

Uncertainty. Uncertainty. What is uncertain in economic systems? tomorrow’s prices future wealth future availability of commodities present and future actions of other people. Rational responses to uncertainty (when the agent is risk-averse): buying insurance (health, life, auto);

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Uncertainty

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  1. Uncertainty

  2. Uncertainty • What is uncertain in economic systems? • tomorrow’s prices • future wealth • future availability of commodities • present and future actions of other people. • Rational responses to uncertainty (when the agent is risk-averse): • buying insurance (health, life, auto); • diversification (typically diversification lowers expected earnings in exchange for lowered risk).

  3. Preferences Under Uncertainty • Think of a lottery. • Win €90 with probability 1/2 and win €0 with probability ½ (states of Nature and probabilities). • U(€90) = 12, U(€0) = 2. • Expected utility is

  4. Preferences Under Uncertainty • Think of a lottery. • Win €90 with probability 1/2 and win €0 with probability 1/2. • U(€90) = 12, U(€0) = 2. • Expected utility is

  5. Preferences Under Uncertainty • Think of a lottery. • Win €90 with probability 1/2 and win €0 with probability 1/2. • Expected money value of the lottery is

  6. Preferences Under Uncertainty • EU = 7 and EM = €45 • U(€45) > 7  €45 for sure is preferred to the lottery risk-aversion (utility of expected value is higher than expected value of utility). • U(€45) < 7  the lottery is preferred to €45 for sure risk-loving. • U(€45) = 7  the lottery is preferred equally to €45 for sure risk-neutrality.

  7. Preferences Under Uncertainty U(€45) > EU  risk-aversion 12 U(€45) EU=7 MU declines as wealth rises. 2 €0 €45 €90 Wealth

  8. Preferences Under Uncertainty U(€45) < EU  risk-loving 12 MU rises as wealth rises. EU=7 U(€45) 2 €0 €45 €90 Wealth

  9. Preferences Under Uncertainty U(€45) = EU  risk-neutrality 12 U(€45)=EU=7 MU constant as wealth rises. 2 €0 €45 €90 Wealth

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