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Chapter 12 31
Chapter 12
Uncertainty
This chapter begins with the idea of contingent consumption and an insurance
market example. Make sure that you define “contingent” since a lot of students
don’t know the term. (The definition is given in the book.) The emphasis in
this first section is on the idea that exactly the same tools that we have used
earlier can be used to analyze choice under uncertainty, so it is worth talking
about what happens to the budget line when the price of insurance changes, etc.
The expected utility discussion is reasonably elementary. However, it is
often hard to motivate the expected utility hypothesis without seeing a lot of
applications. I put it in since some schools might want to have an elementary
treatment of the subject for use in other courses, such as finance courses.
The easiest application of expected utility theory that I could think of was the
result that expected utility maximizers facing actuarially fair insurance would
fully insure. In the Information chapter I talk about moral hazard and adverse
selection in insurance markets, and those might be fun ideas to touch on in class
discussion.
The last three sections on diversification, risk spreading, and the role of the
stock market are important economic ideas. I usually discuss these ideas in
verbal terms and skip the details of the expected utility material. This seems
like a reasonable compromise for a general purpose intermediate micro course.
Uncertainty
A. Contingent consumption
1. what consumption or wealth you will get in each possible outcome of some
random event.
32 Chapter Highlights
B. Utility functions
1. preferences over the consumption in different events depend on the prob-
abilities that the events will occur.
C. Risk aversion
1. shape of expected utility function describes attitudes towards risk.
D. Role of the stock market
1. aids in diversification and in risk sharing.
2. just as entrepreneur can rearrange his consumption patterns through time
by going public, he can also rearrange his consumption across states of
nature.
