Economics of Uncertainity:

We have seen the behaviour of economic agents under conditions of certainty, i.e., the situation in which consequences of any choice made were fully known beforehand. However, once we bring in choices to be made under uncertainty, the theoretical prescriptions  by  far  remain an uncovered domain. As  our income  levels fluctuate, price we  pay  change or health conditions worsened, we need LO model choices accounting for such plausible events. Also, see that most  of  decisions we take are forward looking: planning  a holiday trip, to many or to buy insurance are examples. Decision on these are usually  taken on the  basis of our beliefs about what  is the  optimal plan  for present and  future. Thus, these choices are made in the context of uncertainty Consequently, there is a risk that the assumptions made  in our plans may not materialise. Anticipating such eventualities we resort  to contingencies and probabilities. That is, if we want a realistic model  of  choice, it would  be necessary to include in our models the effects of uncertainties.

It  is  seen that a  person  who has  vNM expected utility preferences over  lotteries will  act as if she is maximising the utility as a weighted average of each state, weights being their probabilities. In this  formulation, the  utility  hnction  is made operational  by  ordinal utility ranking of individual preferences. Consequently, the utility functions are defined upto a positive linear transformation. Agents could be risk averse, risk loving or risk neutral depending on the type of utility functions being concave, convex or linear. An  important insight gained from the expected utility theory is concerning a risk  averse agent who has  the  expected utility of wealth  less than  the utility of expected wealth. Based  on  the  expected utility theory, we explain why  risk-averse individuals will  buy  insurance and risk-loving ones will pay to gamble.