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Uncertainty

Economic systems are inherently uncertain, affecting future prices, wealth, and commodity availability. Individuals and agents face unpredictability not only regarding market conditions but also in the actions of others. Rational responses to such uncertainty often involve risk-averse strategies like purchasing insurance or diversifying investments, despite these choices generally leading to lower expected earnings. This article explores the concepts of expected utility and preferences under uncertainty using lottery examples to illustrate risk aversion, risk-loving behavior, and risk neutrality.

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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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