Microeconomics: Demand Under Risk, Uncertainty, and Imperfect Information

The marginal utility theory based on a single commodity contains several significant weaknesses: - Interactions Between Goods: A change in the consumption of a single good does not occur in a vacuum; it will directly affect the marginal utility of substitute goods and complementary goods. - Impact on Demand: Because the marginal utility of related goods is affected, a change in one good's consumption necessarily impacts the demand for those other products. - Expectation vs. Totality: Consumer behavior is driven by perceptions of the marginal utility they expect to gain from a product, rather than by the total utility itself.

Section Reference: $6.2$
Economic models often operate under the assumption that individuals possess perfect information when buying goods and services.
This assumption implies consumers know two variables exactly: - The exact price they will pay. - The exact amount of utility they will gain from the consumption.
While this assumption holds true for low-cost, immediate-consumption items (e.g., a bar of chocolate), it does not accurately reflect the market for more complex items.

Metadata References: KIB; p42.
For many purchases, especially long-term ones, perfect information is a "reasonable assumption" only in the short term.
Uncertainty increases as the consumer looks further into the future regarding the costs and benefits of a product.
This uncertainty is particularly prevalent in the market for consumer durables.
Definition of Consumer Durable: A consumer good that lasts a period of time, during which the consumer can continue gaining utility from it.
Examples of consumer durables cited include: - Mobile phones. - Tablets. - Cars. - Washing machines.

Uncertainty of Costs: - Initial Purchase: Buying a washing machine may require an immediate cash outlay of $£400$ . This is a certain cost. - Hidden Future Costs: Washing machines are prone to breaking down. A consumer might face an unpredicted repair bill of $£100$ after $2\,\text{years}$ . - Realized Price: Even though it cannot be predicted at the moment of purchase, that $£100$ is a price the consumer must pay, just like the original $£400$ . Thus, the consumer is uncertain of the full "price" the item will entail over its lifetime.
Uncertainty of Benefits: - External Influences: Consumers are often attracted to buy products based on manufacturer brochures, aesthetic appeal, or advertisements on TV and in magazines. - Reality of Use: After using the product for a period, consumers may discover unanticipated negative attributes, such as: - A spin dryer that does not get clothes as dry as hoped. - Excessive noise levels during operation. - Water leaks. - Mechanical failures, such as a sticking door.

Buying consumer durables is inherently a gamble, but so is the purchase of assets.
Assets can be categorized as: - Physical assets (e.g., a house). - Financial assets (e.g., shares in a company).
The primary source of uncertainty for assets is their future price, which cannot be known with certainty at the time of the transaction.

The effect of uncertainty on human behavior depends on individual attitudes toward "taking a gamble."
Distinction between Risk and Uncertainty: - Risk: A condition where the person knows their chances, meaning they understand the probabilities involved (e.g., $25\%$ chance of an outcome). - Uncertainty: A condition where probabilities are unknown.
Economics often analyzes behavior under risk to provide a mathematical framework for decision-making.

Scenario parameters: - A student has an remaining student loan balance of $£105$ . - The student considers buying an instant lottery ticket or scratch card. - The cost of the ticket is $£5$ . - The probability of winning is $1$ in $4$ (or $25\%$ ). - The prize for a winning ticket is $£20$ .
The decision whether or not to purchase the ticket is a function of the student's personal attitude toward risk.

Definition of Expected Value: The average value of a variable after many repetitions: in other words, the sum of the value of a variable on each occasion divided by the number of occasions.
In economic terms, the expected value of a gamble is the amount a person would earn on average if that gamble were repeated many times.
Calculation of Expected Value: 1. Multiply each possible outcome by the probability that it will occur. 2. Sum these values together.
In the lottery ticket example, there are two distinct outcomes: 1. Purchasing a winning ticket. 2. Purchasing a losing ticket.