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Uncertainty
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Gravity
Terms in this set (14)
mutually exclusive
only one state can occur (π1+π2=1)
Contingent Consumption Plan
Depends on the state occuring
Independence Assumption
choice we make in different states of nature (independent)
Expected value
sum of values weighted by the probabilities
E(I)=π1I1+π2I2
E(C)=π1C1+π2C2
Expected Utility
can represent some preferences (not all) with this form
U(c1,c2,π1,π2) = π1
sqrt(C1)+π2
π2*sqrt(C2)
Perfect substitutes expected utility
U(c1,c2,π1,π2)=π1c1+π2c2
Cobb Douglas expected utility
lnU(c1,c2,π1,π2)=π1*lnc1+π2lnc2
Y-axis on uncertainty graph
TU (total utility)
X-axis on uncertainty graph
I (income)
Risk averse uncertainty graph
concave TU function (so diminishing MU)
Risk neutral graph
constant MU (so linear TU)
Risk lover graph
convex TU function (so increasing MU)
Steps when approaching an uncertainty problem
1. determine good and bad states of nature for income and probability
2. set up expected value of income and expected utility; solve the type of risk
3. plug things in to find the answers to whatever the else the problem asks
consumer choice should satisfy:
Budget Constraint and optimization condition (MRS)
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