Introduction to the Economics of Uncertainty and Information

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Introduction to the

Economics of Uncertainty and Information
Timothy Van Zandt INSEAD
November 2004

Copyright 2004 Preliminary and incomplete: Use only with the permission of the author.

Author’s address: Voice: +33 1 6072 4981 INSEAD Boulevard de Constance Fax: +33 1 6074 6192 77305 Fontainebleau CEDEX Email: tvz@insead.edu FRANCE WWW: faculty.insead.edu/vanzandt

Table of Contents

1 Choosing among Uncertain Prospects 1.1 Introduction to decision theory . . . . . . . . . . . . . . . . . . . . . . . 1.2 Lotteries and objective expected utility . . . . . . . . . . . . . . . . . . . 1.3 States of nature and subjective expected utility . . . . . . . . . . . . . . 2 Choosing when there is new information 2.1 Representing information . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2 Bayes’ Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3 Independence and Exchangeability . . . . . . . . . . . . . . . . . . . . . 3 Risk Preferences 3.1 Money outcomes and risk aversion . . . . . . . . . . . . . . . . . . . . . 3.2 Comparing the risk aversion of people . . . . . . . . . . . . . . . . . . . 3.3 Comparing the riskiness of acts . . . . . . . . . . . . . . . . . . . . . . . 4 Market Decisions in the Presence of Risk 4.1 Demand for a state-contingent contract . . . . 4.2 Techniques for characterizing market decisions 4.3 Comparative statics . . . . . . . . . . . . . . . . 4.4 State-dependent utility . . . . . . . . . . . . . .

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79 . 79 . 85 . 96 . 103

5 Markets for state-contingent contracts 109 5.1 Gains from sharing risks . . . . . . . . . . . . . . . . . . . . . . . . . . . 110 5.2 Insurance market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117 6 Asset Markets 6.1 The nature of asset markets . . . . . 6.2 Market

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