L11

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L11

• Buying and Selling Uncertainty

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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)

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Uncertainty

• Two States of the world no rain and rain
• Probabilities
• Goods consumption
• Endowment income in two states
• Possibility of insurance

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Uncertainty and Lotteries
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Budget Constraint
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Preferences (uncertainty)

• Bundle defines a lottery
• Expected value Average payment
• Examples
• Risk aversion
• better than

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Utility

• Uncertainty special preferences
• Von Neumann-Morgenstern
• is a Bernoulli utility function
• Expected Utility
• Useful property

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Examples (Risk attitudes)

• Example 1
• Example 2
• Example 3

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Utility and Risk Aversion
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Uncertainty (three functions)
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Certainty Equivalent

• Certainty equivalent of lottery
• Example
• Example
• Risk Aversion

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Choice of Insurance
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Magic Formulas

• Bernouli utility

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Fair Insurance

• Fair Insurance, why?
• Expected profit
• Free Entry and Law of Large Numbers

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Insurance
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Not Fair Insurance

• When Insurance is not fair
• In optimum (First secret of happiness)