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L11

L11. Uncertainty. 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). Uncertainty.

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L11

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  1. L11 Uncertainty

  2. 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)

  3. Uncertainty • Two States of the world: no rain and rain • Probabilities • Goods: wealth • Endowment: wealth in two states • New: • No markets for but insurance • Consumption bundle = lottery

  4. Insurance contract • Insurance contract • Premium insurers choice • Coverage consumer’s choice Timing:

  5. Uncertainty and Lotteries

  6. Budget Constraint

  7. Translation: (“as if” markets)

  8. Expected value • Lottery (random variable) • Expected value: average payment • Examples

  9. Preferences and Utility • Uncertainty – special preferences • Bernoulli utility function • Von Neumann-Morgenstern utility (Expected utility)

  10. 3 Risk attitudes (aversion) • Example Lottery D:Risk aversion: • Risk neutrality. Risk loving

  11. Risk attitudes • Example 1: • Example 2: • Example 3:

  12. Indifference curves

  13. Marginal Rate of Substitution

  14. Choice of Insurance

  15. Magic formulas

  16. Fair vs. not fair Insurance • Fair premium • Not fair premium • Why? Expected profit of insurer • Free Entry drives profit to zero

  17. Fair premium = full insurance

  18. Partial Insurance First secret of happiness

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