hat Uncertainty All the models considered so far have one thing in common. There is no uncertainty. This is a very restrictive assumption. Often in economic situations there is less than perfect information. Both production and consumption often involve unknown variables that affect the profits and utility of the When an agent makes a decision(about consumption for example) the utility they will receive may be uncertain. decision making under uncertainty be modelled? Random chance of this sort in economics is referred to as nature taking an action. Nature decides which state of the world occurs. For example, a consumer is considering whether or not to purchase car. Unfortunately cars can break down. If the consumer purchases the car. nature "decides"whether the car breaks down or not. These are the two possible states of the world. How he consumer compare the utility from purchasing the car with the utility from keeping their money? Market- What Nerty Lotteries Economists model this sort of decision problem as a choice between lotteries. One lottery involves buying the car(which costs 500)and then facing the uncertainty of a possible break down (which occurs 20% of the time). The other lottery involves keeping the money for sure. 1000 Buying the car Suppose a car is worth 1500 to the agent, and the cost of repairing after a break down is 100 How can a consumer compare these two lotteries c and n? Consumers have preferences over lotteries: Either n>c or c>n. Representing this preference relation as a utility function: Either un ue or ue > un ner preferences over bundles. An analogous argument for the case of preferences over lotteries can be lade. Preferences that satisfy certain consistency requirements can be represented by an expected utility function.Market — What Next? 1 Uncertainty • All the models considered so far have one thing in common. There is no uncertainty. • This is a very restrictive assumption. Often in economic situations there is less than perfect information. Both production and consumption often involve unknown variables that affect the profits and utility of the agents. • When an agent makes a decision (about consumption for example) the utility they will receive may be uncertain. • How can decision making under uncertainty be modelled? • Random chance of this sort in economics is referred to as nature taking an action. • Nature decides which state of the world occurs. For example, a consumer is considering whether or not to purchase a car. Unfortunately cars can break down. If the consumer purchases the car, nature “decides” whether the car breaks down or not. These are the two possible states of the world. • How can the consumer compare the utility from purchasing the car with the utility from keeping their money? Market — What Next? 2 Lotteries • Economists model this sort of decision problem as a choice between lotteries. • One lottery involves buying the car (which costs 500) and then facing the uncertainty of a possible break down (which occurs 20% of the time). The other lottery involves keeping the money for sure. ................................................................................................................................................................................. ................................................................................................................................................................................. u ................................................................................................................................................................... c 1000 0 • un • 500 • • • 0.2 0.8 1 Buying the car Keeping the money • Suppose a car is worth 1500 to the agent, and the cost of repairing after a break down is 1000. • How can a consumer compare these two lotteries c and n? Consumers have preferences over lotteries: Either n º c or c º n. Representing this preference relation as a utility function: Either un ≥ uc or uc ≥ un. • Recall consumer preferences over bundles. An analogous argument for the case of preferences over lotteries can be made. Preferences that satisfy certain consistency requirements can be represented by an expected utility function