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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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