Consumer Theory

UNIT 4 CHOICE UNDER UNCERTAINTY AND

INTERTEMPORAL CHOICE
Structure
4.0 Objectives
4.1 Introduction
4.2 Representation of Uncertainty— Probability Distribution
4.3 Decision-making under Uncertainty
4.3.1 The von Neumann-Morgenstern Expected Utility Function

4.4 Attitude Towards Risk

4.4.1 Risk
4.4.2 Risk Neutrality
4.4.3 Risk Aversion
4.4.4 Risk Preferring

4.5 Risk Aversion and Insurance

4.6 Intertemporal Decision-making
4.6.1 Intertemporal Budget Constraint
4.6.2 Preferences over Two Time Periods: Indifference Curves
4.6.3 Case of a Borrower and a Lender

4.7 Let Us Sum Up

4.8 References
4.9 Answers or Hints to Check Your Progress Exercises

4.0 OBJECTIVES
After going through this unit, you will be able to:
• state the concept of uncertainty and risk;
• discuss the expected utility function and its properties;
• explain how to maximise utility under uncertainty;
• discuss the attitude of an individual towards Risk;
• elucidate how risk aversion is dealt with institution of insurance; and
• appreciate the process of the intertemporal decision-making by the
consumer.

4.1 INTRODUCTION
We have learned in Unit 2 how a consumer decides which combination of
goods and services to buy, given his income and prices of the goods, in order
to maximise his satisfaction. For this, there is a pre-supposition that the
consumer has complete and perfect information and knowledge about the
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transaction. However, in real life situations, there are many uncertainties Choice Under Uncertainty
and Intertemporal Choice
that consumers have to face before they decide. Uncertainty is a fact of life.
In decision-making process, there are many uncertainties and randomness
that a consumer has to take into consideration. For example:
i) Used Car: When you buy a used car, you are very unsure about its
condition. You might be lucky and get a beautifully maintained car with
no mechanical problems, or you might get a lemon or damaged car
(whose mechanical problems are not easily observable).
ii) College/University: Suppose you choose a university for an
undergraduate degree. Your university is very expensive. During the
time of making decision about your college/university choice, how
much do you know about it (or them)? Do you know how many
professors are interesting and informative, and how many are deadly
dull and uninterested in teaching? Do you know what your major will
be? Do you know what a blessings or a curse your roommates or
classmates might be?
iii) Life Insurance and Annuities: If all the events and contingencies are well
known in life, then there is no need for insurance in such a society.
However, when significant uncertainties are present, insurances solve
the problem for such a society. You fear you may die too young, and
you want to buy a life insurance policy to protect your spouse and
children in the vent of your premature death. What kind of policy
should you buy, and how much insurance should you have?
Alternatively, you think you may live too long and you may run out of
savings before you go. You do not want to be a burden to your children.
You heard that you can buy an insurance against this possibility also.
Should you buy an annuity, and how big an annuity should you get?
iv) Investments: You have some money that you are going to invest in bank
term deposits (with minimal risks and also minimal rewards), or in
shares of stocks (with considerable risks but greater rewards). What
should you do?
v) Dangerous activities: You travel between home and college by car, or by
train. Be it any mode, each time you face some risk of a fatal accident.
Do you know what the odds of a road accident are? Suppose you own a
car and are good at driving. But you do not know whether everyone
around on the road is a careful driver. Someone may hit your car and
the damages can be huge and varied. Hence, whenever you drive out
from your house, you are uncertain that you will come back without
getting hit or what will be the amount of accumulated damage in any
accident.
There are countless examples in real life which involve uncertainty. Many of
the things we do increase uncertainty in our lives, whereas other things
reduce it. Sometimes we pay money to buy risks (like gamble, lottery) at
other times we pay money to avoid risks. Under such uncertainties, there
often exist difficulties in decision-making. To tackle this, institutions exist.
Insurance in an economy is another such institution which helps in
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Consumer Theory mitigating risks that arise due to uncertainties. With uncertainties, you
might like to get insurance cover against car accidents. For this reason
agents buy various kinds of insurance (life insurance, car insurance, fire
insurance, crop insurance etc), to cover up for the risk involved or an
unforeseen contingency.
In this unit we shall explain the notion of uncertainty and how it impacts the
consumer’s behaviour. The concept of expected utility function will be
introduced in order to understand consumer’s decision-making under
uncertainty. In this connection, we will explain the concept of risk and an
individual’s attitude towards risk and the basic principle of choosing
insurance.
We shall also throw light on intertemporal decision making, where Inter-
temporal means across the time period. We shall take into consideration the
saving and borrowing by a consumer and how does they affect his/her
decision-making. This we will attempt to discuss with the help of an inter-
temporal budget constraint.

4.2 REPRESENTATION OF UNCERTAINTY—

PROBABILITY DISTRIBUTION

How does uncertainty affect consumer’s decision-making? In the presence

of uncertainty we have what is called— probability of occurrence of an
event. For example, if probability that a consumer’s income will increase is
90 per cent, then there is 10 per cent chance that his income might stay the
same. If there is complete information about the probability of occurrence
of an event, we can construct what is called a probability distribution. A
probability distribution shows the likelihood that a given random variable
will take up any of the given values. For example, the random variable in our
example is the individual’s salary hike. Table 4.1 shows probability
distribution of individual’s salary hike, that is it shows the likelihood that
income hike of the individual will take various values.

Table 4.1: Probability distribution of an Individual’s Salary Hike

Salary Hike (Rs.) Probability

0 (No change) 0.1
1000 0.1
3000 0.1
5000 0.4
7000 0.2
9000 0.1

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This probability distribution is represented below in the Fig. 4.1. Choice Under Uncertainty
and Intertemporal Choice

Probability

0.5

0.4

0.3

0.2

0.1

0 1000 3000 5000 7000 9000 Salary Hike

Fig. 4.1: Discrete Probability Distribution

In the above diagram, we see probabilities of occurrence on the y-axis and

salary hike on the x-axis. Since there is finite number of events in this
example, we call it discrete probability distribution. Given the above
example, we can now say, probability that the salary hike will be Rs. 5000 is
40 per cent and that the hike will be Rs. 9000 the probability is only 10 per
cent.
Next, let us calculate, expected salary hike given the information regarding
the probability of their occurrence. So to calculate expected salary hike, we
multiply each salary hike with its respective probabilities, so we get,
Expected Salary Hike = 0(0.1) + 1000 (0.1) + 3000 (0.1) +
5000 (0.4) + 7000 (0.2) + 9000 (0.1) = 4700
Therefore, expected salary hike is equal to Rs. 4700.
Hence the expected value is nothing but the mean or the weighted average
of a random variable X. The data on random variable will be scattered
around its mean, that is, around its expected value.
Symbolically, Expected Value (EV) = ∑ X� P�
where X� is the random variable value at i and P� is the associated
probability. Accordingly, we require 0 < P� < 1 and also ∑ P� = 1
In the example that we are discussing here, the number of events (salary
hikes) is finite and the probability distribution is simply the vertical bars that
we see in Fig. 4.1. If, however, the number of events (let say height in
centimeters) were infinite, then the probability distribution would look like
the smooth curve as in Fig. 4.2. Such a probability distribution is called a
continuous probability distribution. 77
Consumer Theory

Probability
0
Height (in cm)
cm)
Fig. 4.2: Continuous Probability Distribution

4.3 DECISION-MAKING UNDER UNCERTAINTY

In the previous units, we discussed about the choices that the agents make
under the conditions of certainty. When uncertainty is involved, altogether a
different decision-making process will be followed. Consider an agent who is
to make a choice between two possible investment projects offering
different payoffs with respective probabilities. Please note here that the
decision-maker does not know what would happen once he decides
between the two investment plans, i.e. investment A or B. The outcome
here depends upon some random factors which are out of control of the
decision-maker. The random variable here will be the payoff or benefit to
the decision-maker by investing in either plan. Consider Table 4.2, giving
different payoffs from each plan along with their respective probabilities.
Table 4.2: Probability distribution of payoffs from different investment
Plans

Payoff from Plan A Probability Payoff from Plan B Probability

10 0.1 10 0.0
20 0.3 20 0.3
30 0.2 30 0.4
40 0.2 40 0.3
50 0.2 50 0.0

This is how the payoffs are read— there is 10 per cent chance of getting
Rs. 10 payoff, 30 per cent chance of getting Rs. 20 payoff and 20 per cent
chance each of getting payoff as Rs. 30, Rs. 40 and Rs. 50. Similarly for plan
B, we have the outcomes (payoffs) and their respective probabilities. Now to
choose between plan A or plan B, agent needs to calculate the expected
payoff from each plan.
78
From Plan A, his expected payoff = 10(0.1) + 20(0.3) + 30(0.2) + Choice Under Uncertainty
and Intertemporal Choice
40(0.2) + 50(0.2) = 31.
Similarly, from Plan B, expected payoff = 30.
As we might expect, our agent’s first inclination is to choose the investment
that provides the highest expected monetary value. This approach seems to
make sense. Most people would want to consider the investment from
which they can expect the greatest return. On such basis, our agent will
choose plan A because its expected payoff value is greater than the
expected payoff value of plan B. Hence when faced with uncertainties, it is
natural to believe that the agents maximise their expected monetary
benefits which, in turn, maximises their expected utility. But this is not true
in all cases. Now let us discuss a situation in which maximising expected
monetary value may render different result than maximising expected
utility.

Why Not Maximise Expected Monetary Returns?

Although it seems logical to use expected monetary value as the criterion
for making investment decisions under conditions of uncertainty, this
approach is actually filled with contradictions. Consider the following
example:
Let us say that a patient leaves a doctor’s office with the sad news that he
has exactly two days to live unless he is able to raise Rs. 20,000 for a heart
operation. The patient spends the next two days calling relatives and friends
but is not able to raise a penny. With one hour left to live, the patient walks
dejectedly down the street and runs into a dealer. Instead of offering the
patient Rs. 20,000 outright, this dealer offers him a choice between two
gambles. In gamble A, he will receive Rs. 10,000 with a probability of 0.50
and Rs. 15,000 with a probability of 0.50. In gamble B, the patient will
receive nothing (Rs. 0) with a probability of 0.99 and Rs. 20,000 with a
probability of 0.01. These gambles are summarised in the following
Table 4.3.

Table 4.3: Probability distribution of payoffs from Gamble A and B

Gamble A Gamble B
Prize (Rs) Probability Utility of Prize (Rs) Probability Utility of
Rupee Rupee
10,000 0.5 0 0 0.99 0
15,000 0.5 0 20,000 0.01 1
Expected monetary value = Rs. Expected monetary value = Rs. 200
12,500 Expected utility = 0.01
Expected utility = 0

Obviously, if our patient is a maximiser of expected monetary value, he

would like to choose gamble A, with expected return of Rs. 12,500, whereas
gamble B’s expected return is only Rs. 200. However, there is a catch here. If 79
Consumer Theory our patient chooses gamble A, then it is certain that he will die in one hour,
but if he chooses gamble B, he has at least a 1% chance to live. Hence, the
money to be received by our patient in gamble A is worthless because he
will die, while gamble B promises a chance to live. Therefore, most people
would say that gamble B is the better choice. The reason is obvious. Most
people are interested in more than just obtaining an amount of money. They
are also interested in what that money will bring in terms of happiness or
satisfaction. In this case, because Rs. 20,000 is needed for a lifesaving
operation, any amount below Rs. 20,000 is worthless. Hence, if we
arbitrarily call the value or utility of death 0 and the value or utility of living
1, we can see that from the patient’s point of view, the expected utility of
gamble A is 0 [0(0.5) + 0(0.5) = 0] and the expected utility of gamble B is 0.01
[0(0.99) +1 (0.01) = 0.01]. If people act, so as to maximise their expected
utility, then gamble B is better than gamble A and it is the one that will be
chosen by our patient.
The point of this example, then, is that when making decisions in situations
involving uncertainty, agents do not simply choose the option that
maximises their expected monetary payoff; they also evaluate the utility of
each payoff. We might say that they behave as if they are assigning utility
numbers to the payoffs and maximising the expected utility that these
payoffs will bring.

4.3.1 The von Neumann-Morgenstern (vNM) Expected

Utility Function
In their book ‘The Theory of Games and Economic Behaviour’, John von
Neumann and Oskar Morgenstern developed mathematical models for
examining the economic behaviour of individuals under conditions of
uncertainty. Note that the new utility function is no longer be purely ordinal,
it will have some properties of cardinal utility function; however it will be
providing the basis for the rigorous analysis of choice under uncertainty.
Consider a risky situation, where the decision-maker does not know
beforehand which state of the world will occur. For simplicity we assume
two possible state of the world situations — 1 and 2, with respective
probabilities of their occurrence as π1 and π2. Let c1 denote individual’s
consumption if state 1 occurs and c2, if state 2. One of the convenient ways
to represent von Neumann-Morgenstern expected utility function is in the
following form:
u(c� , c� ) = π� v(c� ) + π� v(c� )

Where, function v(.)* gives the amount of utility attained from some
amount of consumption. Thus vNM expected utility can be written as a
weighted sum of some function of consumption in each state, v(c1) and
v(c2), where the weights are given by the probabilities π1 and π2 (where 0 <
�� < 1 and also �� = 1 with i = 1, 2). If one of the states is certain, so that
π1 = 1 say, then v(c1) is the utility of certain consumption in state 1. Similarly,
if π2 = 1, v (c2) is the utility of certain consumption in state 2.

80
When we say that a consumer’s preferences can be represented by an Choice Under Uncertainty
and Intertemporal Choice
expected utility function, or that the consumer’s preferences have the
expected utility property, we mean that we can choose a utility function
that has the additive form described above.

VNM utility theory is based on the following assumptions:

1) Completeness and transitivity: The consumer’s preference over all the

alternatives, certain and uncertain, are complete and transitive. It is an
obvious extension of the assumption we made for the standard
consumer theory model.

2) Continuity: Suppose consumer prefers alternative X over Y and Y over Z,

that is Y is somewhere between X and Z in the consumer’s preference
ranking. Then there must exist a probability px, with 0 < px < 1, such that
the consumer is indifferent between the middle alternative Y and the
lottery offering best alternative X with probability px and the worst
alternative Z with probability (1 – px).

3) Independence: Suppose consumer is indifferent between alternatives X

and Y, and Z is any other alternative. Consider two lotteries— one with
outcomes X and Z and the other with Y and Z. Suppose both these
lotteries assign the same probability to the indifferent alternatives (i.e.,
X or Y), and therefore the same probability to the other alternative Z.
Then the consumer must be indifferent between these two lotteries.

4) Unequal probabilities: Suppose consumer prefers alternative X to Y.

Consider two lotteries, both having only X and Y as possible outcomes,
with both attaching different probabilities to the two outcomes; then
consumer prefers the lottery that assigns a higher probability to her
preferred outcome X. Thus a consumer would prefer the gamble that
gives him/her better odds of the preferred prize.

5) Compound lotteries: A consumer is given a choice between lotteries.

Lottery L1 is the straightforward lottery that provides certain outcomes
(X1, X 2,…, X�) with respective probabilities (p1, p2,…, p�). Lottery L2 is a
lottery whose outcomes are other lotteries. However, after the
intermediate lotteries play out, it ultimately ends up with a same
certain outcomes, and with the same respective probabilities (p1, p2,…,
p�). Then the consumer is indifferent between L1 and L2. Thus a rational
consumer would focus on the ultimate probabilities of the ultimate
outcomes.

Thus Von Neumann Morgenstern (vNM) Expected Utility theorem says: Let L
be the risky alternative, that is, any lottery. Suppose its outcomes are (X1,
X2,…, X�). These are certain outcomes or other lotteries with respective
probabilities (p1, p2, … , p�). Then the utility of the risky alternative L is the
expectation of the utilities of its possible outcomes. That is:
U(L) = p1 U(X1) + p2 U(X2) + ⋯ + pnU(Xn)
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Consumer Theory Check Your Progress 1
1) Which of the following utility functions have the expected utility
property?
a) u(c1, c2) = 5 [π� v(c� ) + π� v(c� )]
b) u(c1, c2) = π1c1 + π2c2
c) u(c1, c2) = π1 ln c1 + π2 ln c2 + 17

………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………

2) What is a probability distribution? How does it explain the choice under

uncertainty?
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………

3) Consider an individual who invests in different schemes and faces an

uncertain income flow of Rs 5,000, or Rs 8, 000, or Rs 10,000 with
respective probabilities of 10%, 50%, and 35%. Determine the expected
monetary value of the investment schemes.
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………

4) Explain von Neumann Morgenstern utility function.

………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………

4.4 ATTITUDE TOWARDS RISK

How does an individual decide when facing risks? Assuming that the
decision-making by such an individual is rational, his attitude towards risk
82
can be ascertained. In this section we attempt to employ the concept of Choice Under Uncertainty
and Intertemporal Choice
expected utility function to see how ‘rational’ decisions are made in the face
of risk. We will define here, what is called— the risk in choice-making, which
arises due to uncertainty; and how institution of Insurance helps to
overcome such risks.

4.4.1 Risk
Risk is generally perceived as the possibility of facing a misfortune or a loss.
In other words, it is the potential that a choice or a decision made will bring
an undesirable outcome. Like your decision to drive a car on road involves
the risk of your car meeting an accident and hence incurring damage or loss.
That is here, risk is involved with uncertainty of happening or not happening
of an event. Such uncertain situations are often connected to some
associated probabilities of occurrence or non-occurrence of an event.
Now the question arises, “How do people react to events involving risk
compared to those that are risk-free?” There exists heterogeneity in
people’s preference toward risk. Consider an individual, who is asked to
choose between two gambles, G1 and G2. Gamble G1 offers a prize of Rs. 50
with certainty, whereas gamble G2, offers a prize of Rs. 100 with a
probability of 0.50 and no prize with a probability of 0.50. G1 being a sure
thing is obviously less risky than G2. Expected value of the gambles will be
given as follows:
Expected Value (EV) of G1 = 1 × 50 = Rs. 50 (as probability of a certain payoff
is 1.)
Expected Value (EV) of G2 = 0.50 × 100 + 0.50 × 0 = Rs. 50
Although both Gambles have the same EV, one can only be sure about G1 as
G2 is risky in Economic sense. While making a choice between G1 and G2,
some people might be indifferent among G1 and G2; some might prefer G2,
the risky one; and others might choose G1, the safe gamble. From this,
emerges the notion of attitude towards risk. Suppose a consumer is given
the choice between two activities, a risk-free activity with a guaranteed
outcome and a risky activity involving outcomes with some probabilities.
Assuming people prefer to maiximise utility attained from different available
options and not associated monetary payoffs, they can be classified
according to their attitude towards risk into three categories, viz— Risk
Neutral, Risk Averse and Risk Loving. Let’s discuss each one of these three
categories.

4.4.2 Risk Neutrality

A risk neutral person shows no preference between a certain income, and
an uncertain income, given they both have equal expected value. In other
words, he will be indifferent between a risky and a risk-free choice, if both
result in same expected value to him. In our example above of two gambles
(G1 and G2), a risk neutral person would be indifferent between the two, as
both have equal expected value (= Rs. 50).
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Consumer Theory Now we attempt to graphically present behaviour of such an individual.
Consider an individual facing risky activity A that generates a payoff (X) of
� �
Rs. 100 with probability � and a payoff of Rs. 1000 with probability �.
� �
Expected Value (EV) of activity A will be given by (� × 100) + (� × 1000) =
Rs. 775.
Let utility function representing preferences of this individual be given by
U(X) = 2X, where X represents the payoff in Rupees.
Now, consider Fig. 4.3 where Payoffs (Rs) appear on the horizontal axis and
the utility generated by those payoffs, on the vertical axis.
Utility attained when payoff X = 100 (represented by point a) is given by
U(100) = 2(100) = 200;
Similarly, when payoff X = 1000, utility attained (represented by point b) is
given by U(1000) = 2(1000) = 2000.
Expected Utility [E(U)] of the risky activity A will given by
� � � �
[� × U(100) + � × U(1000)] ⇒ [� × 200 + � × 2000] = 1550, this is nothing but
the height at point c, representing mean value of the line joining points a
and b.
Now, suppose a risk-free activity B is offered to the same individual, where
he receives a certain payoff, which equals the EV (expected value) of the
Risky activity A, i.e. Rs. 775. Then, EV of risk-free activity B will also be
Rs. 775, as individual will be receiving the amount with certainty (i.e.
probability = 1).
Utility attained from activity B [let us denote it by U(EV) as activity B’s payoff
is nothing but equal to the EV of activity A] will be given by
U(775) = 2(775) = 1550, which is again equal to the height at point c.
Now, points a (100, 200), b (1000, 2000) and c (775, 1550) can be joined to
form a straight line, representing individual’s utility function. Every point on
this straight line curve tells us how much utility he will receive from any
given level of rupees.
A straight line utility curve indicates that the individual’s attitude towards
risk will be neutral. This stems up from the fact that when faced with two
activities A and B, with former being risky and the latter, risk-free, just
because they both had same expected payoff value (= Rs. 775), the
individual with the given utility function [U(X) = 2X] attained same utility
from both the activities. That is,
Expected utility of risky activity A [E(U)] = Utility from risk-free activity B
[U(EV) ] = 1550.
Note, however, that because the utility function is a straight line, every time
the agent obtains one more Rupee, his utility increases by the same amount.
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To put it another way, the marginal utility of an additional Rupee is Choice Under Uncertainty
and Intertemporal Choice
constant, no matter how many Rupees the agent already has.

U = 2X
Utility from Payoff

b
2000

E(U) = U(EV) c
= 1550

a
200

0 100 EV = 775 1000 Payoff (X in Rs.)

Fig. 4.3: Risk Neutrality

4.4.3 Risk Aversion

Now we consider an individual who has an aversion to risk, i.e. one who
strongly dislikes risk. The utility function representing a risk-averse
individual is not a straight line but rather is concave (refer Fig. 4.4).
Concavity of the function implies that its slope is decreasing, which in turn
implies that this individual exhibits diminishing marginal utility for additional
units of payoff. In other words, the risk-averse consumer is not willing to
incur additional risk for the possibility of a higher valued payoff. Unlike his
risk neutral counterpart, such an individual will not be indifferent between a
risk-free and a risky activity, each of which has the same expected monetary
value.
To graphically understand such a behaviour, let us consider an individual
�
who faces an option to either choose a risky activity A with a 20% (= �)
�
chance of obtaining a payoff of Rs. 36 and a 80% (= �) chance of obtaining
Rs. 100, or go for a risk-free activity B with a certain payoff equal to the
� �
expected payoff of the risky activity A, i.e., Rs. 87.2 �= � × 100 + � × 36�.

Now assume this individual has utility function given by U (X) = √X, where X
is the payoff received. We will proceed in the similar way like we did in case
of risk-neutral individual (Refer Fig. 4.4).

U(36) = √36 = 6, the height at point a; U(100) = √100 = 10, height at the
point b.
85
Consumer Theory � � � �
E(U) of the risky activity A = [� × U(36) + � × U(100)] ⇒ [� × 6 + � × 10] = 9.2,
height at point c, representing mean value of the line joining points a and b.
A risk-free activity B will offer a certain payoff of EV of the Risky activity A,
i.e. Rs. 87.2. EV of risk-free activity B will also be Rs. 87.2.
Utility attained from activity B, i.e. [U(EV)] = U(87.2) = √87.2 = 9.338, which is
equal to the height at point d. Here, we get U(EV) > E(U). That is, this
individual attains higher utility from risk-free activity B, as compared to the
expected utility from risky activity A (9.338 > 9.2). Such a behaviour exhibits
an individual’s risk averseness, where expected utility associated with a risky
choice is less than the utility attained from a certain outcome (= the
expected outcome of the risky choice) of a risk-free choice.

U = √�
b
10
d
U(EV) = 9.338
E(U) = 9.2 c

a
Utility from Payoff

0 36 EV = 87.2 100
Payoff (X in Rs.)
Fig. 4.4: Risk Aversion

4.4.4 Risk Preferring

There are some individuals who actually prefer risky activities to risk-free
ones. These individuals are called risk lovers possessing a risk preferring
attitude. A utility function for such an agent is shown in Fig. 4.5. Note that
the utility function in Fig. 4.5 becomes steeper as the agent’s payoff
increases. Hence, a risk-preferring agent has increasing marginal utility for
additional units of payoff represented by convex utility function. This simply
means that the risk preferring individual is quite willing to take on additional
risk for the possibility of a higher valued payoff. To understand such
behaviour better, consider an example of an individual who faces a choice
�
between a risky activity A, with a 50% �= �� chance of obtaining a payoff of
�
Rs. 5 and a 50% �= �� chance of obtaining Rs. 10, or go for a risk-free

86
activity B with a certain payoff equal to the expected payoff of the risky Choice Under Uncertainty
� � and Intertemporal Choice
activity A, i.e., Rs. 7.5 �= � × 5 + � × 10�.

Now assume this individual has utility function given by U (X) = X � , where X
is the payoff received. Here again we proceed in the similar way like we did
in case of risk-neutral and a risk-averse individual.

U(5) = 25, the height at point a; U(10) = 100, height at the point b.
� � �
Expected Utility, i.e. E(U) of the risky activity A = [� × U(5) + � × U(10)] = [� ×
�
25 + � × 100] = 62.50, height at point c, representing mean value of the line
joining points a and b.

A risk-free activity B offering a certain payoff equal to the EV of the Risky

activity A, i.e. Rs. 7.5, will also have an EV of Rs. 7.5 (as probability of a
certain payoff = 1).

Utility attained from activity B, i.e. [U(EV)] = U(7.5)

= (7.5)� = 56.25, which is equal to the height at point d.

Here, you can easily notice from the figure, that height ce > de, that is, we
get E(U) > U(EV). In other words, expected utility attained by this individual
from risky activity A is greater than the utility he receives from risk-free
activity B giving certain outcome (that is, 62.50 > 56.25). Such a behaviour
exhibits that the individual is risk preferring, with expected utility associated
with a risky choice being more than the utility attained from a certain
outcome (= the expected outcome of the risky choice) of a risk-free
choice.

b
100
Utility from Payoff

c
E(U) = 62.50
U(EV) = 56.25
d

a
25

e
0 5 EV = 7.5 10
Payoff (X in Rs.)
Fig. 4.5: Risk Preferring
87
Consumer Theory
4.5 RISK AVERSION AND INSURANCE
In addition to characterising an agent’s attitude toward risk, expected utility
theory can be of use to us in analysing more applied questions about
insurance and about risk-taking in general. To understand the value of
expected utility theory in such areas, let us consider Fig. 4.6.
Fig. 4.6 is identical to Fig. 4.4. It depicts the utility function of an agent who
is averse to risk. Let us assume that this agent owns a house that has a
current value of Rs. 100 and that she is aware of the possibility that the
house may burn down, in which case the land it is on, will be worth Rs. 36
only. Let us also assume that from previous history, we know that there is a
20% chance that the agent’s house will burn down. Therefore, we can say
that during the next period, the agent is actually facing a gamble in which
�
she will have a house worth Rs. 100 with a probability of 80% (= �) , or she
�
will have land worth Rs. 36 with probability 20% (= �).
� �
Expected value of the gamble = � × 100 + � × 36

= Rs. 87.2

Assuming individual’s utility function to be U (X) = √X, where X is the rupee

value.

U(36) = √36 = 6, the height at point a; U(100) = √100 = 10, height at the
point b. Therefore, the expected utility E(U) is
� � � �
E(U) = [� × U(36) + � × U(100)] ⇒ [� × 6 + � × 10] = 9.2,

height at point c, representing mean value of the line joining points a and b.
The utility from the expected value (or income) of the gamble U(EV) is:

U(EV) = U(87.2) = √87.2 = 9.338, height at point d on the utility

function.
If the agent does nothing, her current state (ownership of the house) is
worth the height cg (= 9.2) to her in terms of utility. Could this risk averse
agent be assured of some certain amount (let it be denoted by Rs. C), which
would give her a level of utility equivalent to the expected utility level from
the risky gamble, i.e. 9.2? Point e on the utility function curve represents
such a possibility.
The corresponding Rupee value on the x-axis associated with point e will be
given by
U(C) = 9.2

√C = 9.2 (squaring both sides to get the value of C)

C = 84.64

88
Note that cg and ef are the same height, where ef represents utility to the Choice Under Uncertainty
and Intertemporal Choice
agent (= 9.2) with a sure payoff of Rs. 84.64. This amount of Rs. 84.64 is
known as the Certainty Equivalent of the Gamble.

Certainty Equivalent (CE)

Certainty equivalent (CE) of a risky activity is the amount of money for
which an individual is indifferent between the gamble and the certain
amount. In other words, it is the amount of money received with
certainty giving a utility level to the individual equivalent to the level
attained by risky gamble. It is also called the selling price, from the fact
that it serves as the definite price at which the activity could be sold, or
at which individual will be indifferent between facing and selling a
gamble.

Our agent can obtain Rs. 84.64 for sure if someone is willing to sell her
insurance on the house for a yearly premium (price) of Rs. 2.56 (= Rs.
87.2 − 84.64). This 2.56 amount is nothing but what is called the Risk
Premium. It is simply the amount which the agent is willing to forego in
order to be indifferent in her choice between a risky gamble and the one
with a certain return. The notion of a risk premium is directly applicable to
insurance policies. An individual who purchases an insurance policy willingly
pays a sum of money, known as an insurance premium (or Risk premium), in
order to guarantee a certain level of monetary value generally associated
with some type of risky activity.

U = √�
b
10
d
U(EV) = 9.338 e
E(U) = 9.2 c

a
Utility from Payoff

f g
0 36 84.64 87.2 100
(CE) (EV) Payoff (X in Rs.)

Risk Premium = 2.56

Fig. 4.6: Risk Aversion and Insurance

89
Consumer Theory

Check Your Progress 2

1) Define the concepts of Expected Value and Expected Utility. Explain
their application in determining the attitude of an individual towards
risk.
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
2) A risk-averse individual is offered a choice between a gamble that pays
Rs. 1000 with a probability of 25% and Rs. 100 with a probability of 75%,
or a payment of Rs. 325. Which would he choose?
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
3) How does insurance help reducing risk?
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………

4.6 INTERTEMPORAL DECISION-MAKING

The word “Intertemporal” simply means “across time”. So far we have
assumed that consumer exhausts all his income in a given time period and
accordingly makes consumption decisions. We did not consider that income
in one time period can be transferred to another time period, that is, our
analysis so far has been static. In this section, we will attempt to look into
decision-making process adopted by an individual across time periods. For
instance, his decision about how to allocate his income through time:
whether to borrow for current consumption or save for retirement; whether
to build up a pension fund or not; whether to save for a holiday or spend all
right away, etc.

4.6.1 Intertemporal Budget Constraint

Under intertemporal decision-making, individual decides about his savings
and borrowings. To begin with this, let us first describe how the budget
constraint changes when there are intertemporal decisions.

90
Up till now, the budget constraint we have been considering is given by, Choice Under Uncertainty
and Intertemporal Choice
p� x� + p� x� = M
Where, p1 is the price of good x1, p2 is the price of good x2 and total income
of the consumer in the given time period is M. Along with this, we have
been assuming that consumer exhausts all his income, so that total
expenditure is equal to total income. Now with intertemporal choices, there
is an intertemporal budget constraint.
Consider an individual who is assumed to live for two periods, 1 and 2,
earning Y1 and Y2 amounts of income, respectively. Let us denote
consumption of this individual in period 1 and 2 by C1 and C2, respectively.
Along with consumption, individual also has an option to either save (then
C1 < Y1) or borrow (then C1 > Y1) in period 1, with savings being given by S1 =
Y1 – C1 (and borrowing is negative saving). The market rate of interest (r) is
assumed to be given and constant, which an individual could earn or pay on
his savings or borrowings, respectively. If consumer saves S1 amount in
period 1, then in period 2 he would earn (1 + r) S1 in income.
Individual under the above conditions is thus faced with the problem of
choosing an optimal consumption stream (C1 and C2) through time, given
the stream of income (Y1 and Y2) and market rate of interest. There are two
possibilities:
If individual decide not to consume the entire Y1 in period 1, i.e., Y1 > C1,
then S1 > 0 (individual saves Y1 – C1 in period 1). Then the budget constraint
of this individual for period 1 will be given by,
C1 + S1 = Y1
Whereas, if he decides to consume more than what he has in period 1, i.e.,
Y1 < C1, then S1 < 0 (individual borrows C1 – Y1 in period 1). This individual
will have to then pay back (1 + r) S1 amount to the lender in period 2. The
budget constraint of this individual for period 2 will be given by,
C2 = Y2 + (1 + r) S1
These two budget constraints can be combined into one by solving for S1.
The intertemporal budget constraint then will be given by,
�� ��
�� + = �� +
1+� 1+�
This means that, if we assume that there are two time periods, then total
��
lifetime income (i.e., Y� + ��� ) is equal to total lifetime consumption (i.e.,
��
C� + ��� ). Which is highlighting the fact that an in lifetime individual cannot
consume more than his income. Income in period 2 is discounted by the
factor (1 + r) to get the present value of future income, this is what is done
with consumption in period 2. Thus, the intertemporal budget constraint
says that the present discounted value of consumption expenditures must
equal the present discounted value of income.

91
Consumer Theory Following is the diagrammatic representation of this budget constraint.
(Fig. 4.7).

C2

�� + �� (� + �) A
Consumer is
a Saver

C2 = Y 2 E

Consumer is
a Borrower

Slope = − (1 + r)

B
0 C1 = Y 1 �� C1
�� +
�+�
Fig. 4.7: Intertemporal Budget Constraint

Graphed in (C1, C2) plane, the intertemporal budget constraint is a straight

line (here AB) with slope – (1 + r). In the above diagram, E is the point of
endowment, which means, consumption in each time period is equal to
respective income. If the consumer chooses a point to the right of the point
E (i.e. in the segment EB), then he is a borrower, as he borrows to consume
in period 1, i.e., C1 > Y1. If he consumes his lifetime income in period 1, then
��
maximum he can consume in period 1 is Y� + , the intercept on
���
horizontal axis. Similarly, if he consumes in any point to the left of the
endowment point (i.e. in the segment AE), then he is a saver in period 1, i.e.,
C1 < Y1. If he saves all his income in period 1, then maximum in period 2 is Y2
+ Y1 (1 + r), the intercept on vertical axis.
Thus intertemporal budget constraint shows all the possible combinations of
consumption in two periods (C1 and C2) available to the consumer, given Y1,
Y2 and r. Given this constraint, the consumer attempts to reach his optimal
by placing his preferences over these allocations. With increase in the rate
of interest, consumption today becomes more expensive than consumption
in the future, hence, the budget constraint becomes steeper around the
endowment and vice versa.

4.6.2 Preferences over Two Time Periods: Indifference Curves

How does a consumer place his preference over consuming today or
tomorrow? Each individual has different preferences. Some might want to
consume all today while some might want to save all today. There might be
92 some who would want to save some today to enjoy higher consumption in
future, while there are others who enjoy greater consumption today Choice Under Uncertainty
and Intertemporal Choice
through borrowing and thus are left with lesser income to consume in
future.
Such differences show that consumer places his preferences over consuming
in two time periods like placing preferences between two goods. Here
consumption in both the time periods (i.e. C1 and C2) will be treated as
“normal goods”, as consumer decides to consume in both the time periods.
This assumption implies that indifference curves showing different
combinations of C1 and C2, keeping consumer utility constant, to be
downward (negative) sloping and convex-shaped (IC1, IC2 and IC3 in the
Fig. 4.8). Downward or a negative slope of IC implies that an increase in
consumption in one period must be accompanied by decrease in
consumption in another period, so as to keep the satisfaction level constant.
The idea of convex indifference curves have been studied in detail earlier.
Convex preferences are a reflection of a decreasing marginal rate of
substitution, which simply means that, as consumption in any one period
increases more and more, the individual will prefer to sacrifice (substitute)
lesser and lesser amounts of consumption in the other period. Fig. 4.8,
shows such preferences.

C2

IC3
IC2
IC1
0 C1
Fig. 4.8: Indifference Curves

How does consumer choose between two time periods, in other words, how
consumer allocates his/her consumption over time? Through intertemporal
budget constraint, all the allocation possible to him/her at the given market
interest rate “r” are derived, and through indifference curves, his/her
preferences over two time periods are described. Consumer optimal is
achieved where the intertemporal budget constraint is tangent to the
convex indifference curve (refer Fig. 4.9). At the point of tangency,
diminishing slope of indifference curve is equal to the constant slope of
intertemporal budget constraint. Thus optimal consumption between two
���
���
time periods (C1*, C2*) occurs where, − �� = −(1 + r)
���
�

Marginal Rate of Substitution (Slope of Indifference curve) is given by

���
���
− �� , and slope of budget constraint is – (1 + r).
���
� 93
Consumer Theory The point of tangency shows consumer choice. The tangency condition is
necessary and sufficient condition to achieve equilibrium, as the preferences
are convex.

C2

�� + �� (� + �)

C 2* (C1*, C2*)

IC

0 C 1* �� C1
�� +
�+�
Fig. 4.9: Optimal Consumption Bundle in Two Periods

4.6.3 Case of a Borrower and a Lender

As we have discussed above, a consumer can choose to save in period 1 by
consuming less than his income for that period, or he may consume more
than the amount earned by borrowing in that period. Now to see whether
the consumer chooses to become saver or borrower in time-period 1,
consider Fig. 4.10 and 4.11 below:

C2 C2

C 2* Y2 E
A (C1*, C2*)

B (C1*, C2*)
Y2 E IC C 2*

IC

0 C 1* Y1 C1 0 Y1 C 1* C1

Fig. 4.10: Case of a Saver Fig. 4.11: Case of a Borrower

94
Fig. 4.10, shows the case of saver. Endowment point in given by point E, Choice Under Uncertainty
and Intertemporal Choice
where C1 = Y1 and C2 = Y2. We can see here that the choice made (C1*, C2*)
is to the left of the endowment (E) given by the tangency of the indifference
curve and the intertemporal budget constraint. That is, the consumer
chooses to consume at point “A” where, C1* < Y1. Hence, this consumer
saves in period 1 and will enjoy greater consumption in period 2.
Fig. 4.11, shows the case when consumer chooses to become borrower in
period 1. Optimal allocation is given by point B (the tangency of the
constraint and the indifference curve), where C1* > Y1. Hence, the consumer
will end up borrowing in period 1 and will have lesser consumption in
period 2.

Changes in Interest Rates

Finally, let us look at what happens when interest rate “r” changes. First we
consider the case when interest rate increases and how this affects
consumer choice? This will be studied under two cases, (a) when individual
initially is a saver, and (b) when he initially is a borrower.

Consider him a saver first (i.e., C10 < Y1), with an initial consumption bundle
given by point A (C10, C20) in Fig. 4.12. When interest rate (r) rises, the
intertemporal budget line (RU initially) pivots around the endowment point
(E) and becomes steeper (TS ultimately). Pivoting of the new intertemporal
budget line around the endowment point indicates that the individual can
always consume the endowment in each period regardless of what “r” is.
The horizontal-axis intercept shifts in to indicate the increased opportunity
cost of present consumption resulting from increased interest rate. In
contrast, the vertical axis intercept must shift up. Now to reach at the new
optimal consumption in two periods bundle, we will be considering both,
the substitution and the income effect of an increase in interest rate.
Substitution effect will cause a fall in C1 and an increase in C2 resulting from
rise in relative price of present consumption (1 + r). C2 will definitely rise, but
nothing can be said about C1. This is due to income effect. An increase in r,
with individual being a saver initially will result in a bigger return on his
savings and hence more income in the next period. Since consumer now has
greater lifetime income, and consumption in both the time period are
considered to be normal goods, both C1 and C2 will increase. For C2, both
substitution effect and income effect works in same direction. But for C1,
they move in opposite direction. Substitution effect decreases C1 while
income effect increases it. Finally whether C1 increases or decreases will
depend on which effect is more dominating. Hence the resultant change in
C1 is ambiguous. Thus, if consumer is a saver and interest rate goes up, he
will continue to be a saver (increased C2 will ensure consumer stays on the
left of the endowment point). This is illustrated in Fig. 4.12, where we
assumed C1 decreased with substitution effect dominating income effect, for
us to be reaching at new optimal consumption bundle (C1*, C2*).

95
Consumer Theory
C2

R
B
C 2*

A
C 20
IC2

IC1
Y2 E

0 C 1* C 10 Y1 S U C1

Fig. 4.12: Consumer initially a Saver and Interest Rate rises

Let us consider the case when interest rate rises and individual was a
borrower in time period 1 (i.e. C10 > Y1). It will become expensive to
consume in first period as relative price of C1 (i.e., 1 + r) will rise, thus
substitution effect will make C1 to fall and C2 to rise like before. An increase
in r, with individual being a borrower initially will result in him paying back
more on its borrowing, reducing his income in period 2 and hence his
lifetime income. Reduced income will induce him to reduce both C1 and C2.
Hence, for a borrower, the income and substitution effects go in the same
direction, leading the individual to definitely reduce C1. But here the result is
ambiguous for C2, as both, income and substitution effects go in opposite
direction.
Check Your Progress 3
1) A consumer, who is initially a lender, remains a lender even after a
decline in interest rates. Is this consumer better off or worse off after
the change in interest rates? If the consumer becomes a borrower after
the change, is he better off or worse off?
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
96
2) What is the present value of Rs. 100 one year from now if the interest Choice Under Uncertainty
and Intertemporal Choice
rate is 10%? What is the present value if the interest rate is 5%?
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
3) As the interest rate rises, does the inter-temporal budget constraint
become steeper or flatter? Give reason.
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………

4.7 LET US SUM UP

In the earlier units we analysed the rational consumer’s choice with the
assumption of perfect information. However, in a real world situation,
perfect information is far from reality. Such lack of perfect information in
turn results in uncertainties or the situations involving risk. We began with
some real life examples of consumers’ choice under uncertainty and then
introduced the concept of risk in a framework of probability distribution. On
the basis of this the method of finding the expected value of the outcome
associated with a risky/uncertain situation was explained. We proceeded
with our model on consumer choice under uncertainties by bringing into
picture the von Neumann-Morgenstern expected utility function, giving the
average utility, or the expected utility, of the pattern of consumption in
uncertain states. In addition to this, we elaborated the procedure involved
in classification of individuals on the basis of their attitudes towards risk by
comparing Expected Utility of the risky activity [E(U)] with Utility from
expected value of a risk-free activity [U(EV)]. On the basis of such
comparison, we came across three types of individuals with differing
attitude towards risk— Risk Neutral, Risk Averse, and Risk Preferring. The
unit further analysed the importance of Insurance for a Risk Averse
individual. With the help of the concept of Certainty Equivalent, we
discussed the concept of Risk Premium— the amount that an individual is
willing to pay in order to guarantee a certain level of monetary value
generally associated with some type of risky activity.
In further sections, we engaged ourselves to get an insight into the
intertemporal decision-making by an individual. We saw how an individual
choose an optimal consumption stream through time. This was achieved
with the help of intertemporal budget constraint, which simply equated
present value of the consumption stream with the present value of the
income stream. We combined the budget constraint confining to two time
periods, with the Indifference curves giving preferences of an individual over
consumption in the two periods— to get to the optimal intertemporal 97
Consumer Theory choice, given the income stream and the market rate of interest. Lastly, we
discussed the case a lender and a borrower by comparing an individual’s
consumption with his income in each period. We further explored how an
interest rate increase affects a lender’s or a borrower’s intertemporal
consumption.

4.8 REFERENCES
1) Varian H.R, (2010). Intermediate microeconomics, W.W. Norton and
Company,
2) Case K.E., Fair R.C and Oster S.M, (2012). Principles of economics, 10th
edition. Pearson Education, USA
3) Bernheim B.D and Whinston M.D, (2009). Microeconomics. Tata
MacGraw Hill, New Delhi
4) Pindyck R.S and Rubenfeld D.L, (1995). Microeconomic. Prentice Hall
International Inc, China
5) Serrano Roberto and Allan M. Feldman, (2013). A Short Course in
Intermediate Microeconomics with Calculus. Cambridge University
Press.

4.9 ANSWERS OR HINTS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1) Functions (a) and (c) have the expected utility property while (b)does
not.
2) See Section 4.2 and answer.
3) Rs. 8,000
4) See Sub-section 4.3.1 and answer.
Check Your Progress 2
1) Hint: Utility of the expected value [U(EV)] of a gamble is compared with
the expected utility [E(U)] of the same gamble to infer about the
individual’s attitude toward risk. If U(EV) > E(U), then individual is risk
averse; if U(EV) < E(U), then he is risk preferring, and if U(EV) = E(U),
individual is risk neutral.
2) Here both, the gamble and the payment offer equal expected payoff of
Rs. 325. Since the individual is risk-averse, he will prefer the risk-free
expected value of the gamble that is Rs. 325 which he receives as
payment, to the gamble itself.
3) See Section 4.5 and answer.

98
Check Your Progress 3 Choice Under Uncertainty
and Intertemporal Choice
1) See Sub-section 4.6.3 and answer.
Hint: Fall in the interest rate will result in fall in consumption in second
period as both substitution and income effects will work in same
direction to reduce it, whereas for consumption in period one, they
work in opposite direction. When consumer decides to remain a lender,
then he will be worse off by settling down with a lower utility level.
Whereas, there is scope of attaining a higher utility level by switching
his behaviour to be that of a borrower after the interest rate fall.
��� ���
2) Present value with 10% interest rate = ���.� = �.�
= 91 (Approx.) and if
interest rate is 5% then it is 95 (Approx.).
3) Steeper, as consumption in period 1 becomes relatively expensive.

99