Chapter 3 - Elements of the Theory of Economic Decision Making under Uncertainty

Abstract

This chapter discusses the elements of the theory of economic decision making under uncertainty. In a world of certainty, actions imply in many instances unique consequences. Therefore, a choice among consequences determines a choice among actions. Under uncertainty, an action taken before the resolution of uncertainty does not uniquely determine the outcome. The outcome will also depend on the state of nature that realizes. The meaning of uncertainty is that the individual does not know the state of nature, although one may have a subjective probability belief over states of nature. The chapter describes some of the results from the theory of decision making under uncertainty. The usefulness of the measures of risk aversion can be seen by considering changes in the optimal portfolio selected by an expected utility maximizer as his initial wealth changes. It is shown that purchases of the risky asset increase, remain unchanged, or decrease with initial wealth as there is decreasing, constant, or increasing absolute risk aversion.