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February 2nd notes

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Alonysisu Siow

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ECO 200
February 2, 2011
Probability, Risk & Lottery (part I)
Decision Making with Uncertain Pay-off:
Example: Bringing an umbrella with you when you go out
a)Bring: If it rains today youll be happy you brought it. If it doesnt rain then youll
be unhappy that you brought it when you didnt need it.
b)Dont bring it: If it rains, youll be unhappy that you didnt bring an umbrella. If
it doesnt rain, then youll either be indifferent or somewhat happy.
Example: Choice of movie
Insurance: dental, auto, health, life, etc.
People tend to be risk averse: refuse to gamble with commodities
However lotto tickets reflect a risk seeking behaviour since it is an unfair low stake gamble
in which many people who are supposedly risk adverse seem to undertake
Expected Value:
Example: consider the lottery/ gamble which pays y with probability p and y with
probability p= 1- p 
Two states: state and state  
1.Y and y are state contingent commodities this means that their value changes 
according to the different state like an umbrella whether its raining or not.
2.Mutual exclusivity
3.Principle of modern economics and finance are based on these concepts
4.The highest payer is the buyer with the highest expectations. This can also be
seen as speculation.
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