Week 3 - Uncertainty Flashcards
What defines a risk environment in consumer theory?
A risk environment is one where the probability distribution of outcomes is or can be known.
How is consumer choice modeled in an uncertain environment?
Consumer choice is based on the probability distribution of consumption bundles, and the consumer selects the best contingent consumption plan they can afford.
What is a contingency or contingent consumption plan?
A plan that specifies the consumption bundle for each possible state of nature, based on known probabilities.
How does a representative consumer make choices under uncertainty?
The representative consumer forms preferences over different contingent consumption plans and chooses the best plan they can afford.
What role do probabilities play in consumer theory under uncertainty?
Probabilities are associated with each consumption bundle, influencing the consumer’s choice based on expected utility.
Why is it important for the representative consumer to have preferences over contingent consumption plans?
It allows the consumer to make rational decisions by evaluating and selecting the most preferred plan under different possible future states.
How can we think about uncertainty in terms of probabilities?
Refer to goodnotes
Why is the expected value of wealth important in decision-making under uncertainty?
It helps consumers evaluate and compare different risky situations by providing a single measure of expected outcome.
How can the utility function under uncertainty be represented?
What is the formula for the expected utility or Von Neumann-Morgenstern utility function?
What property does the expected utility function have?
It has nice additive properties.
What is the significance of the Von Neumann-Morgenstern axiomization?
It is a list of constraints imposed on preferences over considered lotteries, ensuring consistency in expected utility theory.
Why is the expected utility function considered useful in economic modeling?
Because it provides a consistent and additive way to evaluate preferences over risky alternatives.
How can we define the EU of the lottery before participation?
What is the Independence assumption in the context of expected utility?
Each state of nature is considered separately, meaning the probability of one state occurring does not depend on the probability of another state occurring, and there is no interaction between outcomes.
