Initiate ideas Individuals have preferences for consumption and have to choose between dierent consumption

plans, which are plans for how much to consume at dierent points in time and in dierent states
of the world.

The financial market allows individuals to reallocate consumption over time and over states and
hence to obtain a consumption plan dierent from their endowment.

Start with consumption at only one future point in time a consumption plan is simply a random
variable representing the consumption at that date in the dierent states.
In one-period models individuals should be allowed to consume both at the beginning of the
period and at the end of the period. We basically have to model preferences for end-of-period
consumption.

Since current consumption is certain, and we want to focus on how preferences for uncertain
consumption can be represented, we will first ignore the inuence of current consumption on the
well-being of the individual.

Sections 5.25.4 discuss how to represent individual preferences:

Under some fundamental assumptions (axioms) on individual behavior, the preferences can be
modelled by a utility index which assigns a real number to each consumption plan with higher
numbers to the more preferred plans.
Under an additional axiom we can represent the preferences in terms of expected utility, which
is even simpler to work with and used in most models of financial economics.

Section 5.5 defines and discusses the important concept of risk aversion.

Section 5.6 introduces the utility functions that are typically applied in models of financial
economics and provides a short discussion on which utility functions and levels of risk aversions
seem to be reasonable for representing the decisions of individuals

In Section 5.7 we discuss extensions to preferences for consumption at more than one point in
time. Tis covers both the standard case of time-additive expected utility and extensions to habit
formation, state-dependent preferences, and recursive utility.

5.2 CONSUMPTION PLANS AND PREFERENCE RELATIONS

Definition to grab Preference relation: pairwise comparisons in a consistent way. For example, if she if an investor
prefers plan 1 to plan 2 and plan 2 to plan 3, he should prefer plan 1 to plan 3.

Utility index which attaches a real number to each consumption plan. If plan 1 has a higher
utility index than plan 2, the individual prefers plan 1 to plan 2.

A utility function is a function defined on the set of possible levels of consumption. Since
consumption is random it then makes sense to talk about the expected utility of a consumption
plan.
 An expected utility of a consumption plan: The individual will prefer consumption plan 1 to plan
2 if and only if the expected utility from consumption plan 1 is higher than the expected utility
from consumption plan 2.

How do we model We model the uncertainty by a probability space (, F, P).

uncertainty? - The state space is finite, = {1, 2, . . . , S}, so that there are S possible states of which
Probability space exactly one will be realized.
() - The set F of events that can be assigned a probability is the collection of all subsets of .
- The probability measure P is defined by the individual state probabilities p = P(), =
Review from the 1, 2, , S
previous chapters. We assume that all c > 0 and, of course, that p1 + + pS = 1. We take the state
probabilities as exogenously given and known to the individuals.

- a consumption plan by a random variable c on (, , ) c is valued in R+ = [0, )

- a finite state space = {1, 2, . . . , S}, we can equivalently represent the consumption
plan by a vector (c1, . . . , cS), where c [0, ) denotes the consumption level if state
is realized, that is c c()
- Let C denote the set of consumption plans that the individual can choose among
- Let Z R+ denote the set of all the possible levels of the consumption plans that are
considered so that, no matter which of these consumption plans we take, its value will be
in Z no matter which state is realized
- Each consumption plan c C is associated with a probability distribution c, which is the
function c : Z [0, 1]given by

Probability distribution c = Sum of probability of individual state probabilities p - = 1,

2, , S
Assumption In order to simplify the following analysis, we will assume that the individual only cares about the
state-independent probability distribution of consumption generated by each portfolio. This is eectively an
preferences assumption of state-independent preferences.
Example Consider an economy with three possible states and four possible state-contingent consumption
plans as illustrated in the table.
The consumption plans c(3) and c(4) are
dierent, they generate identical probability
distributions.
By the assumption of state-independent
preferences, individuals will be indierent
between these two consumption plans.

Call Z is consumption level For simple Z is a finite set.

Denote by P(Z) the set of all probability distributions on Z that are generated by consumption
plans in C.

A probability distribution on the finite set Z is simply a function : Z [0, 1] with the properties
that () = 1 and ( ) = () + () =
 Call is the preferences of the individual can be represented by a preference relation on P(Z)
which is a binary relation satisfying condition : transitivity and completeness

When 1 2 c l 1 2. And 1 2 is 1 2. 1
2 2 1 1~2

5.3 UTILITY INDICES

nh ngha Utility utility index for a given preference relation is a function U : P(Z) R
index l g 1 2 (1) (2)

Utility index is a utility index is only unique up to a strictly increasing transformation.

f : R R is any strictly increasing function
Composite function V = f U defined by () = (()) is also a utility index for the same
preference relation.

Axiom 5.1 Assume 1, 2 () 1 2 and , [0,1]

(Monotonicity) > 1 + (1 )2 > 1 + (1 )2

Axiom 5.2 Assume 1, 2, 3 (), 1 2 3, , (0,1)

Archimedean
The axiom basically says that no matter how good a probability distribution
1 is, then for any 2 3 we can find some mixture of 1 and 3 to which 2
is preferred.
We just have to put a sufficiently low weight on 1 in the mixed distribution. Similarly, no matter
how bad a probability distribution 3 is, then for any 1 2 we can find some mixture of 1
and 3 that is preferred to 2.
a preference if for any three probability distributions 1, 2, 3 () 1 2 3,
relation has the (0,1) 2~ 1 + (1 ). 3
continui property