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Essays in the economics of uncertainty Epstein, Larry Gedaleah

Abstract

There have been several recent advances in the theory of choice under uncertainty that have extended the restrictive mean-variance framework. Working within the context of a model of expected utility maximization, Rothschild and Stiglitz (1970) and Diamond and Stiglitz (1974) present intuitively appealing and theoretically sound definitions of "greater risk or uncertainty". Moreover, they show that their definitions are useful as well as consistent, in that they may be used to derive comparative statics results in which economists are interested. In the first part of the thesis we argue that the above analyses and most related ones are restricted to models where both the decision variable and the exogenous random variable that defines the stochastic environment, are scalars. Then we extend many of the definitions and results to the context of a general multivariate decision problem. In particular, a generalized notion of risk independence is shown to be relevant to behaviour under uncertainty. This general analysis is then applied to two specific decision problems: first, the standard two-period consumer choice problem where current consumption must be decided upon subject to uncertainty about future income and prices; and second, the corresponding problem in the theory of the firm, where a competitive firm must make some production decisions subject to uncertainty about the prices that will prevail for some products and factors of production. We extend earlier studies of these problems by considering disaggregated models, by adopting theoretically consistent definitions of increased uncertainty and by investigating the role of production flexibility in determining firm behaviour under uncertainty. In both the consumer and producer models the crucial properties of preferences and technology are pointed out and flexible functional forms are hypothesized that are amenable to empirical estimation. The theory of duality plays an important part throughout the formulation and analysis of both models. Finally the basic theory of producer behaviour analysed above is applied to aggregate U.S. manufacturing data for the 1947-71 period. We assume that the capital stock decision must be made one period before the capital comes into operation, subject to expectations about uncertain future prices, while all other factors and outputs may be adjusted fully to current prices. An added important ingredient of the model is the distinction between the capital stock and utilization (depreciation) decisions, the latter being made in each period after that period's prices are known. The consistency of the model with the data is investigated and the empirical significance of our formulation of the capital utilization decision is tested.

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