Uncertainty and Consumer Behavior

"Rational" but bounded, capability limited.

Describing Risk

Probability

Likelihood that a given outcome will occur.

• Objective interpretation of probability
• Subjective probability (perception that an outcome will occur)

Expected Value

• Expected Value: Probability-weighted average of the payoffs associated with all possible outcomes.
• Payoff Value: associated with a possible outcome.

Preferences Toward Risk

Different Preferences Toward Risk:

• risk averse: Condition of preferring a certain income to a risky income with the same expected value.
• risk neutral: Condition of being indifferent between a certain income and an uncertain income with the same expected value.
• risk loving: Condition of preferring a risky income to a certain income with the same expected value.

Risk Aversion and Income:
The extent of an individual’s risk aversion depends on

• the nature of the risk and
• the person’s income.

Risk Premium

Reducing Risk

Diversification

Insurance

Positive Framing: gains more import;
Negative Framing: losses more important.

Behavioral Economics

Not only influenced by economics, it is very subjective.

1. Herd behavior
2. Endowment effect
3. Frame effect

Production

The Production Decisions of a Firm

Inputs: Labor, Material, Capital.

Firms and Their Production Decisions

q = F(K,L)

Production with One Variable Input (Labor)

The Slopes of the Product Curve

The Law of Diminishing Marginal Returns