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Handout 6 - Uncertainty

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Handout 6 - Uncertainty

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psrmkbic12
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Uncertainty - Handout 6

Simona Montagnana1

I. I NTRODUCTION IV. R ISK ATTITUDE


In this handout we describe briefly when people’s When facing risk, individuals are not always willing to
preferences and choices are affected by uncertainty. Risk is pay as much as the expected value of a lottery. This risk
another dimension of economic problems. attitude is personal, as some may be more risk averse than
others.
II. C ONTINGENT C ONSUMPTION We say that:
• an individual is risk averse if his utility value of the
With the expression contingent consumption we refer
expected wealth from a fair lottery is greater than his
to different consumption bundles which depend on the
expected utility of the wealth:
combination of outcomes of events (different states of
nature: e.g. good or bad state) and choices. If we assume u [E(x)] > EU(x) ⇐⇒ U is concave.
there are only two states of nature (1, 2), the utility
function of consumption can be expressed as an individual’s
preferences over consumption in each state. U[E(x)],
E[U(x)]

UTILITY

III. E XPECTED U TILITY


We start by assuming that the choices facing the consumer U (WEALTH)

take the form of lotteries. A lottery is denoted by a vector U[E(x)]


of the form: E[U(x)]

x = (x1 , π1 ; x2 , π2 ; ...; xn , πn )
It is interpreted as: the consumer receive a prize x with x1 x2
x, E(x)
E(x)
probability π, where the probability πi ≥ 0 and ∑ π1 = 1. WEALTH

For a person with utility function u(x), the personal value


for the lottery with expected payoff x is written as u(x).
Fig. 1. Risk aversion
The Expected Utility Function, with only two states of
nature (1, 2), can be expressed as: • an individual is risk neutral if his utility value of the
u(x1 , x2 , π1 , π2 ) = π1 u(x1 ) + π2 u(x2 ) expected wealth from a fair lottery is equal to his
expected utility of the wealth:
If the person cares about the expected utility E [U(x)], u [E(x)] = EU(x) ⇐⇒ U is linear.
then he is willing to pay an amount e such that:

E [U(x)] = u(e)
U[E(x)],
E[U(x)]
Where e is called the certainty equivalent, which is the
UTILITY
amount that makes a person indifferent between that amount
for certain and his EU of the lottery. U (WEALTH)

U[E(x)] = E[U(x)]

x, E(x)
x1 E(x) x2
WEALTH

1 Department of Economics, University of Bath - England


s.montagnana at bath.ac.uk Fig. 2. Risk neutral
• an individual is risk loving if his utility value of the
expected wealth from a fair lottery is less than his
expected utility of the wealth:
u [E(x)] < EU(x) ⇐⇒ u is convex.

U[E(x)],
E[U(x)]

UTILITY

U (WEALTH)

E[U(x)]

U[E(x)]

x, E(x)
x1 E(x) x2
WEALTH

Fig. 3. Risk loving

V. R ISK PREMIUM
The risk premium is the amount that the individual is
willing to pay for avoiding the risk.
We formalize the risk premium r by:

u(x − r) = E [U(x)]

U[E(x)],
E[U(x)]

UTILITY

U (WEALTH)

U[E(x)]

E[U(x)]

r Risk premium

x, E(x)
x1 E(x) x2
WEALTH

Fig. 4. Risk neutral

R EFERENCES
[1] Varian H. (2017) Intermediate Microeconomics, 9th ed.

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