# Intermediate Microeconomics

## 13. Uncertainty

Uncertainty is a part of life. Will you have enough retirement income to retire at age 65? Will the Social Security program be solvent in 50 years? Will a stock that you increase or decrease in value over the next year? Will the business you would like to start be successful or will it fail? How much life insurance should you buy? In the Screencasts/Pencasts for this topic, we extend the model of consumer decision-making to include uncertainty. We will cover the topic of risk, how to measure and how to avoid it. In addition, we will cover expected utility theory, how to determine risk premiums, and explain why insurance companies will never take a fair bet.

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## IntroductionThis Screencast discusses the uncertainty of many decisions that consumers make. In addition, the use of probability as a way to measure uncertainty is discussed. |

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## ProbabilityThis Screencast discusses probability with reference to frequency, subjective probability and probability distributions. |

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## Expected ValueThis Pencast discusses and illustrates how to apply the concept of expected value to decisions that have uncertain outcomes. An example is provided regading how to compute expected value. |

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## Imperfect vesus Perfect InformationIn this Pencast, we show how to compute the gains from perfect information. The example provided compares the expected value of an outcome that is known with certainty to an outcome that is uncertain. |

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## Variance and Standard DeviationGiven that consumers generally prefer less risk to more risk, it is important to develop a measure of risk. In this Pencast, we use the extent to which outcomes vary from the expected value, which is called the variance, as a measure of risk. |

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## Decision Making Under UncertaintyIn this Pencast, we use an example to illustrate how one's preference for risk determines whether they undertake a particular action. |

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## Expected UtilityIn this Pencast, we formalize decision-making uncertainty by developing the basics of expected utility theory, which is similar to expected value but differs in that expected utilty is about the utility one gets from the payoff, which depends on preferences, and expected value is focused solely on the payoff. |

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## Risk AttitudesIn this Pencast, we illustrate three different types of consumers: those that are risk averse, risk neutral and risk preferring (sometimes called risk loving). |

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## Risk AversionThis Pencast illstrates a risk averse consumer's decision to buy a stock, which may rise or fall in value. It is shown that a risk averse person would not accept a fair bet; that is, despite the expected value of buying and not buying the stock being the same, the consumer prefers to take the certain outcome in lieu of gambling. |

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## Risk PremiumUsing a explicit utility function, this Pencast shows how to compute a consumer's risk premium. |

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## Risk NeutralityA risk neutral consumer has a constant marginal utility of wealth. It is shown, in this Pencast, that such a consumer is indifferent between making a fair bet and not undertaking a gamble. Put differently, such a consumer only cares about the expected value. |

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## Risk PreferringIn this Pencast, we illustrate why a consumer that prefers taking risks would be willing to "pay" to gamble. Alternatively put, such a consumer would need to be compensated in order to avoid taking on risk. |

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## Arrow-Pratt Measure of Risk AversionIn this Pencast, we discuss and illustrate the Arrow-Pratt measure of risk aversion. We demonstrate the conditions that depict risk aversion, risk neutrality and a preference for taking on risk. |

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## Degree of Risk Aversion: Part IUsing the Arrow-Pratt measure of risk aversion, this Pencast provides an example a utility function for which the consumer is risk averse. |

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## Degree of Risk Aversion: Part IIUsing the Arrow-Pratt measure of risk aversion, this Pencast provides an example utility function for which the consumer is risk neutral. |

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## Degree of Risk Aversion: Part IIIUsing the Arrow-Pratt measure of risk aversion, this Pencast provides an example utility function for which the consumer is risk preferring (or loving). |

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## Avoiding RiskThis Screencast discusses four different ways of avoiding risk. |

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## InsuranceThis Pencast discusses and provides an example of how a risk averse person would insure against a bad outcome. |

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## Fairness and InsuranceThis Screencast discusses why insurance companies do not offer fair insurance. In addition, the amount charged for insurance by insurance companies is discussed. |

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## An Example of Unfair Premiums using Air InsuranceIn this Pencast, we illustrate the premium charged for accidental death on an airplane is unfair (i.e. overpriced based on the risk). |