Chapter 9 Econ Behav

All situations with uncertainty involve, but not all situations with risk involve uncertainty

means we don’t know the probabilities associated with different outcomes

Ex: Flipping a fair coin is an event with risk (heads or tails) but no uncertainty (we know the probability of each potential outcome)

you would choose the option that maximizes the worst outcome.

This criterion avoids the worst possible outcomes!!!
“Choose the one with the least catastrophic
catastrophe

focuses on relative outcomes

Ex: you would feel no regret if you refused insurance (since you got an A) but you would feel regret if you bought insurance (since you got a B). One measure of the size of the regret is the difference in utility between these outcomes (A vs. B)

amount you should expect to win on average if you played the gamble in the long
run (if you played many many many times).

measure for how widely dispersed
potential outcomes are in the gamble

The average is (100+(−20))/2 = 80/2 = 40, which is also the expected value.
If outcomes are not equiprobable, average ≠ EV

a purchase if the price is equal to the expected value

Ex: Lottery, Assets, Insurance Policies

each unit of consumption provides less marginal utility than the previous unit

In a situation that involves risk but no uncertainty,
we are able to construct expected value (EV) using the
probabilities of different outcomes and the “payouts” of
each possible outcome

combines the use of utility functions to map outcomes (goods, services, money, etc.) into utility space with the concept of expected value for situations involving risk

People have rational
preference orderings for goods and services,
which can be represented using indifference
curves and mapped into an ordinal “utility
space” using a utility function

EV: $35 EU: 1/6 * sqrt 10+ 1/6 *sqrt 20+ 1/6 *sqrt 30+ 1/6 *sqrt 40+ 1/6 *sqrt 50+ 1/6 * sqrt60≈ 5.7

consumption [U(X) = X2]

risk neutral

U(X) = X1/2 or ln(x)]

• Diminishing marginal utility
• Concave utility function
• Don’t like variance

• Constant marginal utility
• Linear utility function
• Don’t care about variance

• Increasing marginal utility
• Convex utility function
• Prefer variance

a certain amount of money that meets the following criteria:
– U(the gamble) = U(CE)