Uncertainty, Contingent Claims and the State-Preference Model

Uncertainty:

Contingent Claims and the State-Preference Model:

Contingent Commodities and Contingent Claims:

Using the simple two-good model we have developed throughout this course think of x1 as consumption when state of the world 1 occurs and x2 as consumption when state of world 2 occurs. We entitle a commodity that is to be delivered in only one state of the world a state contingent commodity or just contingent commodity. In reality if there are n different commodities and m states of the world there will be (n × m) different contingent commodities. For now we consider merely one commodity (consumption) and two states of the world- good (1) and bad (2). Thus in this case there are two contingent commodities.

In the consumers trade contingent claims, state-preference model, which are rights to consumption if, and only if, a particular state of the world occur. So in this framework x1 represents the amount of the good the consumer will receive (or purchase) if state 1 take place and x2 is the amount s/he will receive if state 2 occurs.

Example: Betting in a horse race. The states of the world correspond to how the various horses will place, and a claim corresponds to a bet that a horse will win. If your horse comes in you acquire paid in proportion to the number of tickets you purchased. However the only way to guarantee payment in all states of the world is to bet on all the horses.

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