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Introduction to Semester 2
In the second half of the module we relax some of the assumptions of the perfectly competitive model. This leads us to consider the role of government intervention. And consider some interesting ways that individuals and firms respond to uncertainty and imperfect information. As last semester, you will need to be able to solve problems but I also expect you to be able to discuss the implications of the theory for real life behaviour and policy.
Office hours:
Thursday, 2 4.
E-mailing in advance is always helpful.
Classes:
Thursdays (10-11 and 11-12)
Alternative:
MKR = Morgan, Katz and Rosen Microeconomics (2nd European edition) McGraw-Hill, 2009.
Additional exercises:
Bergstrom and Varian, Workouts in Intermediate Economics
1. Uncertainty
V 17 MKR 17
Test 2:
Answer 3 short-answer questions from 6. Up to 2 hours. (Should only take around 1.) Worth 20%. On material from all weeks, but with a focus on the second half of the course. Sample test given in week 9. Actual test in week 10. 3 sections, equal weights. Section A is multiple choice. (Similar style questions to test 1.) Section B is compulsory short answer questions. (Similar style questions to test 2.) Section C asks you to answer 1 longer question from 3. 2 hours. Worth 70%. On material from all weeks. Mock exam given out in week 11.
Exam:
Expectations
As well as mastering the concepts discussed in the lectures, you need to practice the techniques we cover. I will cover one or two problems in each lecture as an introduction, but you will need to work on the problem sets before the class. Bergstrom and Varians Workouts provide many additional exercises. Please let me know if there are any problems, or if anything can be done to improve the running of the course. Do come to me in the first instance.
Introduction
Uncertainty is pervasive. Many of the choices we make include a element of risk. Economic theory can help us to understand the choices made in situations where there is risk. Examples:
Career choices Insurance markets Investments Gambling
Topic objectives
To learn the language of expected utility theory. To understand risk aversion and risk-seeking. To consider examples where EUT provides insights
Insurance Investment
Reading
Varian, Chapter 12 Morgan, Katz and Rosen, Chapter 6
If the third toss is tails you win 8. And so on (16, 32, 64)
If I make a profit, the money will be donated to the Surrey Economic Society.
This means that we can apply the tools of straight-forward consumer theory (budget constraints and indifference curves) to situations that involve uncertainty.
For example:
The choice over whether or not to buy a lottery ticket. If I do not buy a lottery ticket my wealth will remain the same. If I buy a lottery ticket then I will lose 1 if none of my numbers come up and gain 1000000 if it is the winning ticket.
0.4
Endowment
1
Budget constraint could be extended if the individual could offer the same bet to others
Consumption if heart
ECO2051 Intermediate Microeconomics
If the prize was 33 the expected value would be: 0.33 0.75 + 1 0.25 = 0.25 0.25 = 0
The budget constraint for a fair gamble gives the fair-odds line. Draws a line between all the possible expected values.
ECO2051 Intermediate Microeconomics
0.33
Endowment
Consumption if heart
ECO2051 Intermediate Microeconomics
Another example
In this case were gambling on the throw of a dice.
If its a six receive 4 times the stake (and keep the stake). Otherwise the stake is lost.
What would the budget constraint look like? Whats the expected value of the gamble? How would we need to change the game to make the gamble actuarially fair?
Consumption if six
1 6 Slope= 5 1 = 5 Endowment 1
We generally put the worse outcome on the horizontal axis, but we need not. Notice that the actual budget constraint for the gamble and the fair-odds line need not be the same.
ECO2051 Intermediate Microeconomics
Next: preferences
Choices are made over contingent commodities bundles of goods as represented by points on the budget line. The individual is not making a choice about the state of the world, of course they would prefer to win the gamble, but that choice isnt theirs to make. In the examples we have been considering the choice is over how much to gamble.
The utility of a contingent consumption plan depends on consumption in the two states of the world and the probability of each state of the world occurring. The expected utility form is: 1 , 2 , 1 = 1 1 + 1 1 2 Expected utility is a weighted average of the utility of the two possible consumptions with the weighting dependent on the probabilities.
ECO2051 Intermediate Microeconomics
An expected utility function is also known as von-NeumannMorgenstern (vNM) utility function. Cobb-Douglas utility CD 1 , 2 , 1 = 1 1 2 1 is a vNM utility function, despite appearances, since: log CD 1 , 2 , 1 = 1 log 1 + 1 1 log 2
1
Once the state of the world is known you will only care about consumption in the SoW that prevails, the other will be irrelevant.
This is known as the independence axiom.
Illustration of independence
Suppose utility is given by: 1 , 2 , 3 = 1 1 + 2 2 + 3 3
where 1 + 2 + 3 = 1.
1 2
1 2
The MRS for consumption in SoW 1 and consumption in SoW 2 does not depend on what consumption is in SoW 3.
Gamble 1A
Gamble 1B
Gamble 2A
Gamble 2B
Winnings
1
Chance
100%
Winnings
1 0
Chance
89% 1%
Winnings
0 1
Chance
89% 11%
Winnings
0
Chance
90%
10%
10%
Then if I offer you a choice between the following two new gambles:
Gamble D: With probability , I run gamble A, and with probability 1 I run gamble C. Gamble E: With probability , I run gamble B, and with probability 1 I run gamble C.
Risk averse agents prefer to get the expected value of a gamble with certainty.
Risk aversion
Utility
14
10.5 0.75 14 + 0.25 0
Notice that the expected utility of the gamble is lower than the utility of the expected value. I.e. 1 1 + 2 2 > 1 1 + 2 2 This is the definition of risk aversion.
10.5
14
consumption
Risk loving
Utility
14
It is also possible to be risk loving, the opposite of risk aversion. This is preferring gambles over getting their expected value for certain. I.e. 1 1 + 2 2 < 1 1 + 2 2
consumption
45
In equilibrium
Equilibrium follows exactly as it would in all other situations. The individual chooses the contingent consumption bundle which maximises his utility given the budget constraint he faces. So a risk averse consumer will not accept an actuarially fair gamble.
Risk premia
Utility
14
10.5 0.75 14 + 0.25 0
Risk premium is what youd need to be paid to be compensated for taking the risk. Its calculated as the difference between what youd be willing to pay for the gamble and its expected value.
0.75 14 + 0.25 0
10.5
14
consumption
Risk premium