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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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Introduction

This Screencast discusses the uncertainty of many decisions that consumers make. In addition, the use of probability as a way to measure uncertainty is discussed. [Play ScreenCast]


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Probability

This Screencast discusses probability with reference to frequency, subjective probability and probability distributions. [Play ScreenCast]


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Expected Value

This 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. [Play Pencast]


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Imperfect vesus Perfect Information

In 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. [Play Pencast]


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Variance and Standard Deviation

Given 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. [Play Pencast]


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Decision Making Under Uncertainty

In this Pencast, we use an example to illustrate how one's preference for risk determines whether they undertake a particular action. [Play Pencast]


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Expected Utility

In 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. [Play Pencast]


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Risk Attitudes

In this Pencast, we illustrate three different types of consumers: those that are risk averse, risk neutral and risk preferring (sometimes called risk loving). [Play Pencast]


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Risk Aversion

This 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. [Play Pencast]


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Risk Premium

Using a explicit utility function, this Pencast shows how to compute a consumer's risk premium. [Play Pencast]


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Risk Neutrality

A 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. [Play Pencast]


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Risk Preferring

In 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. [Play Pencast]


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Arrow-Pratt Measure of Risk Aversion

In 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. [Play Pencast]


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Degree of Risk Aversion: Part I

Using the Arrow-Pratt measure of risk aversion, this Pencast provides an example a utility function for which the consumer is risk averse. [Play Pencast]


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Degree of Risk Aversion: Part II

Using the Arrow-Pratt measure of risk aversion, this Pencast provides an example utility function for which the consumer is risk neutral. [Play Pencast]


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Degree of Risk Aversion: Part III

Using the Arrow-Pratt measure of risk aversion, this Pencast provides an example utility function for which the consumer is risk preferring (or loving). [Play Pencast]


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Avoiding Risk

This Screencast discusses four different ways of avoiding risk. [Play ScreenCast]


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Insurance

This Pencast discusses and provides an example of how a risk averse person would insure against a bad outcome. [Play Pencast]


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Fairness and Insurance

This Screencast discusses why insurance companies do not offer fair insurance. In addition, the amount charged for insurance by insurance companies is discussed. [Play ScreenCast]


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An Example of Unfair Premiums using Air Insurance

In this Pencast, we illustrate the premium charged for accidental death on an airplane is unfair (i.e. overpriced based on the risk). [Play Pencast]


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