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Most of the material covered so far deals with a world of certainty. Decision makers know the effects of consumption, employment, output, or pricing choices. This chapter considers decisions under conditions of uncertainty, in which economic actors cannot be sure of outcomes. Risk (we use the words risk and uncertainty interchangeably) relates to the existence of a range of possible outcomes that result from a decision. Specifically, the analysis treats an outcome x as the result of a gamble or lottery. The value of the outcome is random, and the probability of a particular realization of x can be described by a probability density function (or pdf), f(x). The chapter develops a model of risk preferences that relates to the nature of a utility function. The model is applied to ways of measuring differences in risk preferences. Finally, the model is applied to choices related to insurance.
KeywordsUtility Function Risk Aversion Risk Premium Risk Preference Utility Level
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