UNCERTAINTY

Chapter 17
Topics
Degree of Risk.
Decision Making Under Uncertainty.
Avoiding Risk.
Behavioral Economics of Risk.
Risk and Probability
Risk - situation in which the likelihood of
each possible outcome is known or can
be estimated and no single possible
outcome is certain to occur

A probability is a number between 0 and

1 that indicates the likelihood that a
particular outcome will occur.
Frequency.
Let n be the number of times one particular
outcome occurred during the N total number of
times an event occurred.
We set our estimate of the probability, , equal to
the frequency:
= n/N.
A house either burns or does not burn.
If n = 13 similar houses burned in your neighborhood
of N = 1,000 homes last year, you might estimate the
probability that your house will burn this year as
= 13/1,000 = 1.3%.
Subjective Probability and
Distribution
subjective probability - our best
estimate of the likelihood that an
outcome will occur

A probability distribution relates the

probability of occurrence to each
possible outcome.
Figure 17.1 Probability
Distribution
(a) Less Certain (b) More Certain

Probability, %
Probability, %

40 40
Probability Probability
distribution distribution

30 30

20 20

10 10

10% 20% 40% 20% 10% 30% 40% 30%

0 1 2 3 4 0 1 2 3 4
Days of rain per month Days of rain per month
Probability Distribution
(cont).
mutually exclusive when only one of
the outcomes can occur at a given time.

exhaustive when no other outcomes

than those listed are possible.

Where outcomes are mutually exclusive

and exhaustive, exactly one of these
outcomes will occur with certainty, and the
probabilities must add up to 100%.
 Expected Value
Gregg, a promoter, schedules an outdoor
concert for tomorrow.
How much money hell make depends on the
weather.
If it doesnt rain, his profit or value from the
concert is V = $15.
If it rains, hell have to cancel the concert and
hell lose V = $5, which he must pay the band.
He knows that the weather department forecasts
a 50% chance of rain
 Expected Value (cont).
The expected value, EV, is the
value of each possible outcome
times the probability of that
outcome:
EV Pr (no rain) Value(no rain) Pr (rain) Value(rain)
1 1
$15 $5 $5
2 2

where Pr is the probability of an

outcome,
so Pr(rain) is the probability that rain
occurs.
Variance and Standard
Deviation
variance (2) - measures the spread of the
probability distribution.

standard deviation ()- the square root of

the variance.
Holding the expected value constant, the smaller the
standard deviation (or variance), the smaller the
risk.
Table 17.1 Variance and
Standard Deviation: Measures
of Risk
Decision Making Under
Uncertainty
Suppose that Greg strikes a new
agreement with the band by which he
pays only if the weather is good and the
concert is held. What would be the
expected value and variance for this
case?
EV = $7.50
2 = $56.25
= $7.506
Example 2
Suppose that there is a sales job opportunity that
is entirely based on commission Income earned
depend on how much you sell. There are two
outcomes: the first possible outcome is
successful outcome where you earn $2000,
and the second possible outcome is less
successful outcome where you earn $1000.
Suppose that each outcome occurs with
probability .

Q1: What is the expected income for this job

opportunity?
Example 2
Now suppose that there is another sales job
opportunity that pays a fixed salary of $1510.
However it is known that there is a slight
chance that the firm goes out of business in
which case you earn $510 in severance pay.
Suppose that the probability that the company
does not go out of business is 0.99 and the
probability that firm goes out of business is
0.01.

Q2. What is the expected income for this job?

Example 2

Income from Possible Sales Job

Job 1 Expected Income

E(X1 ) .5($2000) .5($1000) $1500

Job 2 Expected Income

E(X 2 ) .99($1510) .01($510) $1500

Example 2
The following tables show two job opportunities
that a worker has. For each job opportunity,
calculate the variance and standard deviation.
JOB 1 (COMMISSION BASED SALES POSITION)
Outcome 2 (less
Outcome 1 (success)
successful)
Prob = 0.5
Prob =0.5
Income $2000 $1000

JOB 2: SALARY BASED

Outcome 1 (Firm Outcome 2 (Firm
stays in business) goes out of business)
Prob = 0.99 Prob =0.01
Income $1510 $510
Example 2
Standard deviations of the two jobs are:

Pr1 X 1 E ( X ) Pr2 X 2 E ( X )
2 2

1 0.5($250,000) 0.5($250,000)
1 250,000 500
2 0.99($100) 0.01($980,100)
2 9,900 99.50
The two jobs have the same expected value
($1500), but differ in their risk. The first job
has a higher standard deviation, and is
therefore riskier.
 If there are two job opportunities for a
worker, it seems the risk of the job along
with the expected income matters when
the worker decides which job opportunity
to take.
A person who enjoys taking risks will
prefer the first job. A person who avoids
risk will take the second job.
Example 3
However, the following example demonstrates that
risk and the expected income alone are not
sufficient to determine the choice under
uncertainty. The following are two job opportunities
with different mean and standard deviations.
Job 1: Expected income = $1600; Standard
deviation = 500
Job 2: Expected income = $1500; Standard
deviation = 99.5
As you can see, job 1 has high risk but it also has a
high return (high expected value). On the other
hand, job 2 has low risk, but expected income is
low as well. Therefore, it is not clear which job
opportunity the worker is likely to choose.
Example 3:
Unequal Probability Outcomes
Probability The distribution of payoffs
associated with Job 1 has a
greater spread and standard
deviation than those with Job 2.

0.2
Job 2

0.1
Job 1

Income
$1000 $1500 $2000
Preferences toward risk
To analyze an individuals choice under
uncertainty, we need to know the consumers
preference towards risk: Some people may prefer
high risk high return job, but others may prefer
low risk low return job.

Also, notice that those who gamble are willing to

take high risk-low expected return option.

Therefore, we have to make one more

assumption regarding individuals behavior: that
is, if there are two job opportunities, then
we will assume that the individual chooses
the job that has higher expected utility.
Expected Utility Theory
We suppose for simplicity that utility depends
only on wealth
u = U(w),
where w is wealth/income
Then if theres uncertainty about the outcome,
so that the two possible outcomes are wlow and
whigh, then expected utility is given by:

E(u) = Pr[w= wlow]*U(wlow) + Pr[w= whigh]*U(whigh)

IMPORTANT NOTE: Expected utility is NOT

U(E(w)) i.e. its NOT the utility of the
expected income.
Expected Utility Theory
expected utility (EU) - the probability-
weighted average of the utility from each
possible outcome.
For example, Greggs EU from the outdoor
EU Pr (no rain) U Value(no rain) Pr (rain) U Value(rain)

concert is:
1 1
U $15 U $5 ,
2 2
 Expected Utility (cont).
fair bet - a wager with an expected value
of zero.

Example: you pay a dollar if a flipped coin

comes up heads and receive a dollar if it comes
up tails. Because
1 you
1expect
to win half the
lose
time and half
$1 the $1
time EV is:
0.
2 2
Expected Utility (cont).
risk averse - unwilling to make a fair
bet
risk neutral - indifferent about making
a fair bet
risk preferring - willing to make a fair
bet
Expected Utility: Example 1
Irma, who is risk averse, makes a choice
under uncertainty. She has an initial
wealth of $40 and has two options:
nothing and keep the $40.
buy a vase.

Her wealth is:

$70 if the vase is a Ming and
$10 if it is an imitation.

Irmas subjective probability is 50% that it

is a genuine Ming vase.
Expected Utility: Example 1

Utility, U
U(Wealth)
c
U($70) = 140
0.1U($10) + 0.9 U($70) = 133 f
d
U($40) = 120

0.5U($10) + 0.5 U($70) =

e
U($26) = 105 b

a
U($10) = 70

0 10 26 40 64 70 Wealth, $
Risk premium





A Risk Averse Individual
A person whose utility function is concave
picks the less risky choice if both choices
have the same expected value.

risk premium - the amount that a risk-

averse person would pay to avoid taking a
risk
Expected Utility: Example 2
Example: A worker is considering a new but risky job opportunity
where there are two likely outcomes. The first outcome is a good
outcome where s/he earns $30,000. The second outcome is a bad
outcome where s/he earns $10,000. For simplicity, we assume that
his/her utility depends only on her income and that utility curve
has the shape given in fig 1.
Total utility

B
1
8

A
1
0

Income (in
1 3 $1000)
Expected Utility: Example 2

Q1.
i.If the probability for good outcome is 0.5
and bad outcome is 0.5, what is the
expected income and what is the expected
utility for this worker?
ii.In the graph, plot expected utility and
expected income combination (E(I), E(U)) .
Q2.
i.If the probability for good outcome is 1/3
and bad outcome is 2/3, what would be
expected income and expected utility?
ii.Plot expected utility and income
combination in the graph.
 Expected Utility: Example 2
From Q1 and Q2, we observe the following.
For any probability distribution, the expected utility is
always on the segment A B.
Any expected utility
and income
Total utility combination will be on
this segment
B
18

A
10

10 30 Income (in
$1000)
Risk averse individual

Remember: The individual whose utility curve is

concave is considered risk averse.

To see this point, consider again the case where

probabilities of good outcome and bad outcome are
both . His/her expected income is $20,000 and
expected utility is 14, which is on the segment AB.

Now further suppose that, in addition to the risky job

opportunity, the individual also has another job
opportunity that pays $20,000 without risk. Notice that
the amount is exactly equal to the expected income of
the risky job.
Then, it can be seen from Figure in Slide 34 that,
expected utility for the riskless job is higher
than that of risky job.
Risk averse individual
Moreover, we can notice, that this is because
(i)the expected utility for risky job lies on the segment AB,
(ii)the expected utility for the riskless job is determined by
the utility curve itself, and
(iii)by the concavity of the utility function, the utility curve
always lies above the segment AB.
Extensions:
a) different probability distributions (other than prob=
): if the utility curve is concave, the riskless job always
has higher expected utility than the risky job, provided
they both have the same expected income.

b) two risky jobs: the risk averse person will choose the
less risky of the two jobs, provided they both have the
same expected income.
Risk averse individual

Expected utility for riskless job

Total
utility

18 B

U (20)
14
A
10

10 20 30 Income (in $1000)

Expected utility for risky job

 Risk aversion and the risk
ypremium
Utilit

E
18
C Distance between CF Risk
14 F
A premium; the maximum amount the
10 consumer will pay to avoid taking risk.
In this case, $4000.

10 16 20 30 Income (in $1000)

If the exp. income for the risky job is $20,000, the exp. utility is 14.
However, this level of utility also can be achieved if there is a job
that pays $16,000 without risk.
The difference between the expected income of the risky
income and the riskless income that achieves the same
level of utility is called the risk premium and interpreted as
the maximum amount the consumer will pay to avoid taking
risk; its the distance CF above ($4000).
Risk Neutral
Someone who is risk neutral has a
constant marginal utility of wealth:
Each extra dollar of wealth raises utility by
the same amount as the previous dollar.
the
utility curve is a straight line in a utility and
wealth graph.

a risk-neutral person chooses the option

with the highest expected value,
because maximizing expected value
maximizes utility.
Risk Neutral

If the utility curve is

a straight line, the
individual is risk
neutral.

The individual is
indifferent between
risky option and the
option without risk as
long as expected
wealth from risky
option is the same as
the wealth from risk
free option.

Risk Lover: Example 1

An individual
with an
increasing
marginal
utility of
wealth is risk
preferring:
willing to take
a fair bet.
Risk Lover: Example 2
Remember: Individuals with convex utility curve
are called Risk Loving individuals
Utility 18 B

3 A
Incom
As can be seen from the graph, if ethe new
risky job has two
possible outcomes, good outcome with income equal to
30,000 and a bad outcome with income equal to 10,000, then
expected utility will be on the segment AB. Notice that the
utility curve always lies below the segment due to the
assumed convexity of utility curve.
Risk Lover: Example 2
Therefore, if there is riskless job opportunity
with income equal the expected income of
the risky job, the risky job will have higher
expected utility. This is because,
(i)the expected utility of the risky job is

determined by the segment AB,

(ii)the expected utility of the riskless job is

determined by the utility curve itself, and

(iii)the utility curve lies below the segment AB

due to the assumed convexity. (See figure 3)

Risk Lover: Example 2

Therefore, if the utility curve is convex, the

individual will choose the risky job provided
that the expected income of the risky job is
the same as the income of the riskless job.
This is the reason why individual with convex
utility curve is called risk loving individual.

For example, if both outcomes have probability

equal to , then the expected income is 20,000
and expected utility is 10.5. If there is a riskless
job opportunity (job_2) that pays 20,000, then
expected utility for job_2 will be clearly lower
(see figure on slide 42). Therefore, the individual
will choose risky job.
Risk Lover: Example 2

Utilit
y
18 B

Figure
4
10.5

A
3
10 20 30 Income

Expected utility for the riskless job

 Practice
Describe Larry, Judy and Carol's risk
preferences. Their utility as a function of
income is given as follows
Larry: U L I 10 I .
Judy: U J I 3I 2 .
Carol: U C I 20 I .
Different Preferences Toward
Risk
Risk Aversion and Income
Theextent of an individuals risk aversion
depends on the nature of the risk and on the
persons income.
Otherthings being equal, risk-averse people
prefer a smaller variability of outcomes.
The greater the variability of income, the more
the person would be willing to pay to avoid the
risky situation.
 Different Preferences
Toward Risk
Risk Aversion and
Indifference Curves
Panel (a) applies to a person
who is highly risk averse:
An increase in this individuals
standard deviation of income
requires a large increase in
expected income if he or she
is to remain equally well off.
Panel (b) applies to a person
who is only slightly risk
averse:
An increase in the standard
deviation of income requires
only a small increase in
expected income if he or she
is to remain equally well off.
Measure of Risk Aversion:
Arrow-Pratt
Avoiding/Reducing Risk
Consumers are generally risk averse
and therefore want to reduce risk
Four ways consumers attempt to
reduce risk are:
Just Say No
Obtain Information
Diversify
Insure
Reducing Risk The Stock
Market
The extent to which diversification reduces
risk depends on the degree to which various
events are correlated over states of nature.
If invest all money in one stock, then take
on a lot of risk
If that stock loses value, you lose all your
investment value
Can spread risk out by investing in many
different stocks or investments
Ex: Mutual funds
Correlation and Diversification (cont).

If you know that the first event occurs,

you know that the probability that the second
event occurs is lower if the events are negatively
correlated
and higher if the events are positively correlated.

The outcomes are independent or uncorrelated

if knowing whether the first event occurs tells
you nothing about the probability that the
second event occurs.
Diversification can eliminate risk if two events
are perfectly negatively correlated.
Correlation and Diversification:
Example 1
Suppose that two firms are competing
for a government contract and have an
equal chance of winning.
Because only one firm can win, the other
must lose, so the two events are perfectly
negatively correlated.
Correlation and Diversification:
Example 1
You can buy a share of stock in either
firm for $20.
The stock of the firm that wins the contract
will be worth $40,
the stock of the loser will be worth $10.
If you buy two shares of the same
company, your shares are going to be
worth either $80 or $20 after the contract is
awarded.
Correlation and Diversification:
Example 1
Their expected value is:
$50 = (1/2 x $80) +(1/2 x $20)

And the variance:

1 2 1 2
$900 $80 $50 2 $20 $50 .
2

However, if you buy one share of each, your two

shares will be worth $50 no matter which firm wins,
and the variance is zero.
Correlation and Diversification

The more negatively correlated two

events are, the more diversification
reduces risk.

Diversification does not reduce risk if two

events are perfectly positively
correlated.
Correlation and Diversification:
Example 2
Suppose a firm has a choice of selling air
conditioners, heaters, or both
The probability of it being hot or cold is 0.5
How does a firm decide what to sell?
Diversification (cont).
Income from Sales of
Appliances
Cold
Hot Weather
Weather

Air
conditioner $30,000 $12,000
sales

Heater sales 12,000 30,000

Diversification Example 2
If the firm sells only heaters or air
conditioners their income will be either
$12,000 or $30,000
Their expected income would be:
1/2($12,000) + 1/2($30,000) = $21,000
Diversification Example 2
If the firm divides their time evenly between
appliances, their air conditioning and heating sales
would be half their original values
If it were hot, their expected income would be
$15,000 from air conditioners and $6,000 from
heaters, or $21,000
If it were cold, their expected income would be
$6,000 from air conditioners and $15,000 from
heaters, or $21,000

So regardless of whether the weather is hot or cold,

income is constant at $21,000; no risk.
Insurance: Example 1
Risk averse individuals are willing to pay for
insurance to avoid risks; If an individual
purchases an insurance policy, then insurance
company will pay a certain amount of money if
bad outcome occurs.
Because Scott is risk averse, he wants to insure
his house, which is worth $80 (thousand).
There is a 25% probability that his house will burn
next year.
If a fire occurs, the house will be worth only $40.
With no insurance, the expected value of his house
is:
(1/4 x 40) + (3/4 x 80) = $70
Insurance: Example 1
The variance of the value of his house
is
1 2 3 2
4 $40 $70 4 $80 $70 $300.
Insurance: Example 1
fair insurance - a bet between an insurer
and a policyholder in which the value of the
bet to the policyholder is zero.

The insurance company offers to let Scott

trade $1 in the good state of nature (no fire)
for $3 in the bad state of nature (fire).
This insurance is fair because the expected value of
this insurance to Scott is zero:

1 3
$3
4
4 $1 $0.
Insurance: Example 1
Because Scott is risk averse, he fully insures by buying
enough insurance to eliminate his risk altogether.

Scott
pays the insurance company $10 in the good state of nature
and
Receives net amount of $30 in the bad state (i.e. $40 $10)
In the good state,
he has a house worth $80 less the $10 he pays the insurance
company, for a net wealth of $70.
If the fire occurs, he has a house worth $40 plus a payment
from the insurance company of $30 , for a net wealth, again, of
$70.
Insurance: Example 1
Insuranc Fire No Fire Expecte Variance
e (Pr = (Pr = d
0.25) 0.25) Wealth
No 40 80 70 300
Yes 70 70 70 0

Scotts expected value with fair insurance, $70, is

the same as his expected value without insurance.
The variance he faces drops from $300 without
insurance to $0 with insurance.
Scott is better off with insurance because he has
the same expected value and faces no risk.
Insurance
To avoid possible confusion, it should be
noted that the risk premium is not
necessarily equal to the amount that
consumer actually pays for insurance.
Insurance: Example 2
Suppose a homeowner faces a 10%
probability that his house will be
burglarized and he will suffer a $10,000
loss. Assume that he has $50,000 worth of
property.

Now suppose that the home owner

purchases an insurance policy that pays
him $10,000 if his house is burglarized.
The insurance costs him $1,000.
Insurance: Example 2

If the insurance policy is actuarially fair (so that the

cost of insurance = expected loss), then risk averse
individuals will fully insure against any possible loss.
In other words, he will buy enough insurance so
that the policy pays out the full amount of the loss.
The policy in the example above is actuarially fair
because Expected loss = (0.1)($10,000) + (0.9)(0)
= $1,000, which is the cost of the insurance.
Expected loss = insurance premium
Reducing Risk Insurance
For the risk averse consumer, guarantee of
same income regardless of outcome has
higher utility than facing the probability of
risk
Expected utility with insurance is higher than
without
Same expected income but one with no risk; risk
averse will buy it
Risk neutral will be indifferent
Risk lover will not buy the insurance
The Law of Large Numbers
Insurance companies know that although single
events are random and largely unpredictable, the
average outcome of many similar events can be
predicted
When insurance companies sell many policies,
they face relatively little risk
In the example discussed, assume firms to be risk
neutral
The premiums they take are used to pay expected
losses
Insurance companies generally charge more than the
expected loss
Reducing Risk Actuarially
Fair
Insurance companies can be sure total
premiums paid will equal total money
paid out
Companies set the premiums so money
received will be enough to pay expected
losses
Behavioral Economics
Sometimes individuals behavior
contradicts basic assumptions of
consumer choice
More information about human behavior
might lead to better understanding
This is the objective of behavioral
economics
Improvingunderstanding of consumer choice
by incorporating more realistic and detailed
assumptions regarding human behavior
Behavioral Economics
There are a number of examples of
consumer choice contradictions
You take at trip and stop at a restaurant
that you will most likely never stop at
again. You still think it fair to leave a 15%
tip rewarding the good service.
You choose to buy a lottery ticket even
though the expected value is less than the
price of the ticket
Behavioral Economics
Reference Points
Economists assume that consumers place a
unique value on the goods/services
purchased
Psychologists have found that perceived
value can depend on circumstances
Youare able to buy a ticket to the sold out
music concert for the published price of $125.
You find out you can sell the ticket for $500 but
you choose not to, even though you would
never have paid more than $250 for the ticket.
Behavioral Economics
Reference Points (cont.)
The point from which an individual makes a
consumption decision
From the example, owning the concert
ticket is the reference point
They value items more when they own them
than when they do not (endowment effect)
Losses are valued more than gains (loss
aversion)
Behavioral Economics
Fairness
Individuals often make choices because
they think they are fair and appropriate
Charitable giving, tipping in
restaurants
Some consumers will go out of their
way to punish a store they think is
unfair in their pricing
There has just been a big snowstorm, so you stop at the hardware
store to buy a snow shovel. You had expected to pay $20 for the
shovelthe price that the store normally charges. However, you find
that the store has suddenly raised the price to $40. Although you
would expect a price increase because of the storm, you feel that a
doubling of the price is unfair and that the store is trying to take
advantage of you. Out of spite, you do not buy the shovel.