Intermediate Microeconomics, Games and Behaviour Week 1
Allocating scarce resources: economic agents trade of marginal benefits against costs
Individual -> decision -> outcome
The single person decision problem: uncertainty and time
1. Risk and uncertainty
Uncertainty: likelihood of outcomes unknown
Risk: likelihood of outcomes known
-> we use risk and uncertainty interchangeably
Calculating the expected value
Expected value: Probability - weighted average of the payoffs associated with all possible
outcomes.
Payoff: value associated with a possible outcome.
Variability: the extent to which the possible outcomes of an uncertain situation differ.
The expected value of Y -> E(Y)
E(Y)= Pr1.y1 + Pr2.y2
Y1, y2 = payoffs (in this example: income) Pr1, Pr2 = probabilities of y1 and y2, respectively
Utility of the expected value does not consider the risk involved -> U[E(Y)]
Expected utility does consider the risk involved -> E(U)
Expected utility: Sum of the utilities associated with all possible outcomes, weighted by the
probability that each outcome will occur.
Utility of expected income: Sum of possible outcomes, weighted by their probability of
occurring, and finding the utility of that number.
Main assumption of expected utility theory: individual preferences over risky outcomes satisfy
specific axioms (completeness, transitivity, continuity and independence).
A decision maker facing a decision problem with a risky payoff is rational if he chooses an action
that maximizes his expected utility.
Risk neutral: condition of being indifferent between a certain income and an uncertain
income with the same expected value.
Risk averse: condition of preferring a certain income to a risky income with the same
expected value.
Risk loving: condition of preferring a risky income to a certain income with the same
expected value.
Allocating scarce resources: economic agents trade of marginal benefits against costs
Individual -> decision -> outcome
The single person decision problem: uncertainty and time
1. Risk and uncertainty
Uncertainty: likelihood of outcomes unknown
Risk: likelihood of outcomes known
-> we use risk and uncertainty interchangeably
Calculating the expected value
Expected value: Probability - weighted average of the payoffs associated with all possible
outcomes.
Payoff: value associated with a possible outcome.
Variability: the extent to which the possible outcomes of an uncertain situation differ.
The expected value of Y -> E(Y)
E(Y)= Pr1.y1 + Pr2.y2
Y1, y2 = payoffs (in this example: income) Pr1, Pr2 = probabilities of y1 and y2, respectively
Utility of the expected value does not consider the risk involved -> U[E(Y)]
Expected utility does consider the risk involved -> E(U)
Expected utility: Sum of the utilities associated with all possible outcomes, weighted by the
probability that each outcome will occur.
Utility of expected income: Sum of possible outcomes, weighted by their probability of
occurring, and finding the utility of that number.
Main assumption of expected utility theory: individual preferences over risky outcomes satisfy
specific axioms (completeness, transitivity, continuity and independence).
A decision maker facing a decision problem with a risky payoff is rational if he chooses an action
that maximizes his expected utility.
Risk neutral: condition of being indifferent between a certain income and an uncertain
income with the same expected value.
Risk averse: condition of preferring a certain income to a risky income with the same
expected value.
Risk loving: condition of preferring a risky income to a certain income with the same
expected value.
