February 2nd notes
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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 you’ll be happy you brought it. If it doesn’t rain then you’ll
be unhappy that you brought it when you didn’t need it.
b)Don’t bring it: If it rains, you’ll be unhappy that you didn’t bring an umbrella. If
it doesn’t rain, then you’ll 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
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 it’s raining or not.
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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