Choice

Prepared by: Eskender D. (M.Sc.)

Introduction
Note that, information is a key input in decision
making.
Decision made under uncertainty of information
involves some kind of risk.
Uncertainty is a situation which can result in a
number of outcomes but one is not sure as to
which outcome is to be materialized.
On the other hand, risk is a consequence that
one has to face as a result of the variability of
outcomes from uncertain situation.
intr
To analyze the choice behavior under uncertainty we
need to quantify/ measure/ risk.
To quantify risk, we need to know all the possible
outcomes of an uncertain situation and the likely hood
of occurrence of each of these events => Probability.
Ex- If we toss a fair die there are six equally likely
outcomes.
The probability that each side turn up is 1/6.
Probability can either be objective or subjective.
We say probability is objective, when probability is
assigned based on observation with regard to the
frequency at which the outcome occurred in the past.
probability is called subjective probability, when
probability is assigned based on personal
assumption.
Utility Function under Uncertainty

If the consumer has reasonable preferences

about consumption in different circumstances, a
utility function can be used to describe these
preferences.
under conditions of uncertainty some additional
structure, called probability, needs to be added
Thus the utility function
to the choice problem.
is defined based on the consumption levels as well as the
probabilities of the state of nature. Let C1 & C2 represent consumptions in two states
and let 1 &  2 be their respective probabilities, then we can write our utility function
for the different consumption states as U (C1, C2, 1 &  2 ).
 Expected Utility
Expected Utility – is outcome expected on
average.
Is the weighted average of all possible
outcomes of an event (the weights being
Eg.probabilities).
Take an event that can result in two possible outcomes.
X1 = Outcome 1
X2 = Outcome 2
E(X) = Expected Outcome
Let 1 is the probability of outcome 1 and
 2 is the probability of outcome 2, then E(X) = 1 X1 +  2 X2.
 Expected Utility……
The formalization of consumer choice theory
under uncertainty was initially by Neuman and
Morgenton.
The central premise of the theory is that
consumer’s choose the alternative with the
Likehighest expected
other utility functions, the expected utility
utility functionrather than
can be subject the
to monotonic
highest The
transformation. value.
specific form of the utility function depends on the nature of
individual consumer preferences. In consumption possibilities state 1 & 2 are perfect
substitute U(C1, C2, 1 &  2 ) = 1 X1 +  2 X2. The Cobb Douglas form is also

possible. U(C1, C2, 1 &  2 ) = C 11 C 

2
2 . By taking the monotonic transformation

we can re-write the utility function as 1 lnC1 +  2 lnC2. But, the former representation
doesn’t have the expected utility property, while the latter does.
Expected Utility,,,,,, cont’d
On the other hand, the expected utility function
can be subject to some kinds of monotonic
transformation and still have expected utility
property.
This special kind of monotonic transformation is
called positive affine transformation which
has the form of V(U) = au + b, where a > 0.
Positive affine transformation means multiplying
the utility function by some positive number and
adding a constant.
Expected Utility,,,,,, cont’d
Economists argue that we can apply an affine
transformation to expected utility and get
another expected utility function that represents
the same preferences.
 However, if any other kind of transformation is
applied, it will destroy the expected utility
property.
There are compelling reasons why expected
utility is a reasonable for choice problems in the
face of uncertainty.
The fact that outcomes of the random choice are
consumption goods that will be consumed in
different circumstances means that ultimately
only one of those outcomes is actually going to
Expected Utility,,,,,, cont’d
The consumption that will be available to the
consumer under the two states of nature can be
taken as independent with what the consumer
will have if it didn’t occur.
 And such additive form of expected utility
function is acceptable for mutually
exclusive uncertain outcomes.
 Expected Utility,,,,,, cont’d
If there are n outcomes with their respective probability, C1- 1 , C2-  2 , C3-  3 - - -Cn-
n , then the Expected utility will be E(U) = 1 C1+  2 C2 +  3 C3+-- - - + n Cn

N.B. The expected utility function satisfies the condition that the marginal rate of
substitution between the two goods is independent of how much there is of the 3rd good.
For example U(C1, C2,C3 1 ,  2 & 3 ) for a given utility function
u (C1, C 2, C 3)
MRS12=MU1/MU2= C1
u (C1, C 2, C 3)
C 2
1u (C1)
= C1 Thus, from this we can conclude that U(3)
 2 U (C 2)
C 2
will not be involved in the calculation of MRS12.
Variability
Variability – refers to the event to which the
individual outcomes are likely to vary from their
expected value.
We use variance or standard deviation to see
the variation of individual outcomes from their
expected value.
Variability

Variance =  2 =  i  Xi  x 
n 2

i 1

= 1 [X1 – E(X1)]2 +  2 [X2-E(X2)]2 +------ +  n [Xn-E(Xn)]2

Choice with high variability results in high risk and similarly choice with low variability
results in low risks.

Example

Outcome 1 Outcome 2
Income probability Income probability
Business 1 2000 0.5 1000 0.5
Business 2 1510 0.99 510 0.01

Expected income of business 1 =>E(1) = 0.5(2000)+0.5(1000)=1500

Expected income of business 2 =>E(2) = 0.99(1510) +0.01(510) = 1500


Variance=  2 =  i  Xi  x 
n 2

i 1

Variance 1=0.5(250,000) +0.5(250,000) = 250,000

Variance 2= 0.99(100) + ).01(980100) = 9900
The outcome of the first business deviate from their expected value more than the second
business and so is more risky. The preference of an individual will depend on his risk
behavior.
Risk aversion
Risk aversion is a tendency to prefer a given
amount of income with certainty than taking a
gamble with high possible return and possible
loss.
For risk averse person the utility from a given
amount of income is greater than the expected
utility from different levels of income with similar
expected value.

Take a person whose utility depends on the level
of income as follows. Suppose the person
currently has 20,000 she is considering a
business which will increase her wealth to 30,000
if the business succeeds but reduce her wealth
 Risk aversion…..
Each success and failure has equal probability of 0.5. A utility for each state is given as
follows.
U(20,000) = 16, U(10,000) = 10, U(30,000) = 18
Expected utility of wealth = 0.5U(30) + 0.5U(10)
= 0.5(18) + 0.5(10)
= 14
U(20) > E(U), for U(20) is 16 and E(U) is 14. Because of this the risk averse consumer
accepts this gamble.
Note that: Risk aversion prefers a certain income to a risky income with the same
expected value.
Risk Aversion
UTILITY

u (30)=18 u (wealth)
u (20)=16

.5u(10)+.5u(30)=14

u(10) =10

10 20 30 WEALTH
Risk aversion
The risk averse consumer has a concave utility
curve. This implies that the slope of a utility
curve gets flatter as wealth increases.
The reason is that risk averse consumer has a
diminishing marginal utility of income.
 The marginal utility of income decreases with
increasing level of wealth.
This implies that the gain in utility from a given
amount of additional wealth is smaller than the
loss in utility from a comparable loss in wealth.
That is why such a person always refuses to
accept a gamble whose expected value is less
than expected utility..
Risk Loving
This is a situation where the utility from a given
amount of wealth (income) is less than the
expected utility.
Risk Loving
 The risk lover consumer has a convex utility function.
 The slope of the utility function gets steeper and steeper
as wealth increases.
 For such consumer, marginal utility increases with
increasing level of wealth.
 This implies that the gain in utility from a given amount of
additional wealth is greater than the loss in utility from a
comparable loss in wealth.
 That is when such a person always accepts a fair gamble.
 The curvature of the utility function measures the
consumer’s attitude towards risk.
 The more concave the utility curve, the more risk averse
the consumer is.
 In contrast, the more convex the utility curve, the more
risk lover the consumer is.
Risk Neutral
If a persons is indifferent between a given
amount of wealth with certainty and expected
value the person is said to be risk neutral.

u (wealth)

Given U(10)=6
U(20)=12
U(30)=18
Risk Neutral,,,
There are two outcomes if the person succeed he
will get additional birr of 20, and if he losses he
will loose 20 birr.
 Each, loss and success, have 0.5 probability.
Will the person accept the gamble, if he is risk
neutral?
DIVERSIFICATION
 Given that a consumer is a risk averse.
 He minimizes the risks of uncertainty, by diversifying his holding
or assets. When one puts his effort in different types of
(unrelated) activities, the loss from badly performing activities
can be compensated by gain from well performing activities.
 By this method one can minimize his/her risk, this method of
minimizing risk is said to be diversification.
 Ex: Consider a person thinking of investing Br. 1000 in two
companies, one is heater producing and the other is air
conditioners producing company.
 The share of stock for both companies currently is sold for Br.
100 each. The next season is equally likely to be hot or cold.
 If the next season turns out to be cold, the securities of the
heaters company will be worth Br.200 each and securities of Air
Conditioners Company will be worth of Br.50 each. And if the
next season turns out to be hot the reverse will happen. Let’s
compare two cases:
 DIVERSIFICATION
1) If the person puts the whole investment in one of the companies say heater.
Outcomes Probabilities
Cold 200,000 (200X1000) .5
Hot 500,00 (50X1000) .5

2) If the person equally divides his investment and put in the two companies:
and if the weather turns out to be cold.

Outcomes
From heater 100,000 (200x500) 125,000 certain income
Air conditioner 25,000 (50x 500)

If the weather turns out to be hot

From Air conditioner 100,000 (200x500) 125,000 certain income.

Heater 25,000 (50x500)
Risk Spreading
In the absence of formal insurance, a group of individuals
can agree to share a loss incurred by each individual from
their group.
Each consumer (individual) in a group spreads his/her risk
over all of the other consumers and there by reduces the
amounts of risk.
Ex: Consider a situation of an individual who had Br.3500
and faced a 0.1 probability of Br.10,000 loss. Suppose that
there were 1000 such individuals. On an average, 10 losses
are expected to occur, thus Br.100,000 will be lost each year.
Suppose that the 1000 individuals decide to insure one
another.
If anybody incurs 10,000 loss, each of the 1000 individuals
contribute Br.10 to the loss that individual is facing. By this
they minimize their loss. On average one individual is
expected to pay. Br.100.
End of lecture