Lecture 5

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Uncertainty and Consumer Behavior

"Rational" but bounded, capability limited.

Describing Risk


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



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


The Production Decisions of a Firm

Customer Producer
Consumer preferences Production Technology
Budget constraints Cost Constraints
Consumer choices Input Choices

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

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