Uncertainty

Lecture 5

1 / 68
Introduction

Everything is uncertain.
We don't know what state of nature we will be
in tomorrow.
We looked at consumer choice over
consumption bundles.
Now we will look at consumer choice over a
variety of risky alternatives.

2 / 68
Introduction

How much insurance should I buy?

What is the optimal portfolio given my

attitude towards risk?
Should I cross the street when the light is
red?

3 / 68
Probability Overview

The expected value of a random variable Y is the long

run average value the random variable will take over
many repeated trials
It is the weighted average of all possible values
(also called expectation or mean)
If Y is n
discrete E[Y ) = ∑ pi xi
i =1

4 / 68
Probability Overview

Lets say X is the roll of a die, which has 6 possible

outcomes all equally likely

E[X ) = 611 + 12 + 13 + 14 6 + 156+ 166 6 6

=35
If you were to roll a fair die 1,000,000,000,000 times, on
average you
would get a value of 3.5

5 / 68
Probability Overview

EXAMPLE
I give you £100 if you flip a heads and £0 if
you flip a tails. What is your expected payoff
from this game?

6 / 68
Probability Overview
The variance of some random variable X is a measure of
how spread out the distribution is. If the variance is high
You are less likely to get a value close to the mean

n
Var[X ) = ∑ pi (xi -
E[X ))2
i =1

Var[X ) = E[X 2) - (E
[X ))2

The standard deviation of X is just the square

root of the Variance

7 / 68
Decision Making Under
Uncertainty

People now have preferences over lotteries

People will pick the lottery that gives them
the highest utility.
You don't know exactly what utility you will
get, however.
People maximize their expected utilities
The expected utility of some action is the
probability weighted sum
of utilities you get associated with each
possible outcome.
8 / 68
Decision Making Under
Uncertainty
Suppose with you the following lottery.
With probability 1 , you win £10 and with probability 1

you win £1
2
2

Your utility function is U = 10 * w where w is wealth.

9 / 68
Decision Making Under
Uncertainty

1
EU = * 10(10) + 1 * 10(1) =
55
2 2

10 /
Decision Making Under
Uncertainty

EXAMPLE
Suppose you have a dice roll and you win the value of the
dice roll (if you roll a 6 you get $6)
Write down an equation for expected utility of an
individual who has a utility function U = ln w (don't
actually calculate the number).

11 /
Decision Making Under
Uncertainty

Two people might face the same lottery, but they will get
a different expected utility.
I buy lottery tickets, many people don't.
The shape of your utility function determines your attitude
over risk.

12 /
Decision Making Under
Uncertainty

A fair bet is a wager with an expected value of 0

You pay $10 to play the lottery and the expected value of
the ticket is $10 This is a fair bet. On expectation you
do not lose money.

13 /
Decision Making Under
Uncertainty

EXAMPLE
You win the value of the dice roll (roll a 6 get $6 for
example) If you have to pay £4 to play this game, is
that a fair bet?

14 /
Decision Making Under
Uncertainty

Suppose I offer you a fair bet.

People who are risk neutral are indifferent between taking
this bet or not
People who are risk loving will always take
this bet People who are risk averse will not.

15 /
Decision Making Under
Uncertainty

Let's look at the risk averse people first.

If somebody is risk averse, they have a diminishing
marginal utility to wealth.
Their utility function is concave.
The extra utility they get from one more dollar is less
than they got from the last.

16 /
Decision Making Under
Uncertainty

1
Suppose somebody's utility function is U
=W2
ThisYou
person can
win $2 play
with the following
probability game.
1 or you win $0 with
probability 1
2
2
The expected value of this game is $1

17 /
Decision Making Under
Uncertainty

The person's expected utility from this

lottery is
1

1
1
= having
EU of
The person's utility 5 * (2) the
2 + 5 * (0) 2
$1 for sure is (1) 2 = 1.
= 7
This person gets a higher utility from $1 for sure than a
bet whose
expected payoff is $1.
This person is risk averse.

18 /
Decision Making Under
Uncertainty

The risk premium is the amount that a risk averse person

will pay to avoid taking a risk.
In the previous example, we know the lottery gives us an
expected
utility of .7.
To find the risk premium, we need to find the amount of
money we would be willing to give up to eliminate risk
altogether.
The lottery in this case has an expected value of $1,
how much of that $1 would I give up?

19 /
Decision Making Under
Uncertainty

1
(X ) = 7
2

X = 49

I am indifferent between playing the lottery with an

expected value of
$1 and having $0 49 cents for sure.
The risk premium is $0.51. I would give up $0 51 to
avoid risk altogether.

20 /
Decision Making Under
Uncertainty

EXAMPLE
With probability
4
1 the car turns out to be bad and is
worth $400
With probability 3the car turns out to be good and is
4
worth $1600
What is the expected payoff from buying this car?
1
If this person has a utility function U = W 2 , what is the
expected
utility of buying this car?
What is the risk premium? What is the most this person
would be
willing to pay for this car?

21 /
Decision Making Under
Uncertainty
This is what a risk-averse person's utility function
looks like.

This person would give up 14 dollars to have no

risk at all. 22 /
Decision Making Under
Uncertainty

Now let's look at a risk neutral person.

A risk-neutral person has a constant marginal utility over
wealth, her
utility function is a straight line.
One extra dollar is worth just as much to her no matter
how much money she has.

23 /
Decision Making Under
Uncertainty

The utility she gets from the expected value of the bet
is exactly equal to the expected utility.
A risk neutral person will take the bet with the highest
expected value.

24 /
Decision Making Under
Uncertainty

Suppose somebody has a utility function U = W

This person can play the following game.
You win $2 with probability 1 or you win $0 with
probability 1
2
2
The expected value of this game is $1

25 /
Decision Making Under
Uncertainty

Will this person take the

bet?
The expected utility of the
bet is 1 1
22 + 0 =
1
2
The utility of having $1 for sure is exactly
the same.
The presence of risk does nothing.

26 /
Decision Making Under
Uncertainty

Now let's look at a risk loving person.

A risk loving person has an increasing marginal utility of
wealth, they will always take a fair bet.
Their utility function is convex.
This person has a negative risk premium.
The expected utility of some bet is higher than the utility
she gets from the utility of the expected value.

27 /
Decision Making Under
Uncertainty

28 /
Decision Making Under
Uncertainty

To summarize
Somebody is risk averse if U (E [X )) > E [U (X ))
Somebody is risk averse if U (E [X )) = E [U (X ))
Somebody is risk loving if U(E [X )) < E[U(X ))

29 /
Decision Making Under
Uncertainty

EXAMPLE
If you flip a heads I give you £10, if you flip a tails I give
you £5. What is the most each of the following people
would be willing to pay for this game?
1
1 U = (W ) 2

2 U=W
3 U=
(W )2
Draw each person's utility function showing the
expected value,
expected utility and risk premia.

30 /
Decision Making Under
Uncertainty

The curvature of the utility function is what determines

somebody's risk aversion
One commonly used measure of this curvature is the
Arrow-Pratt measure of risk aversion

d2U(W )/dW 2
ρ
(W ) = -
dU(W )/d
(W )

31 /
Decision Making Under
Uncertainty

The numerator of this expression is the second derivative.

If utility is concave, this will be negative
ρ is positive if somebody is risk averse and it is negative if
they are
risk loving.

32 /
Decision Making Under
Uncertainty

EXAMPLE
What is the Arrow-Pratt measure of risk aversion for the
following utility functions?

1
U =
W2
U =
2W
W2
U =

33 /
Avoiding Risk

There are a lot of ways people can avoid or

decrease risk One such way is through
diversification.
Diversification simply means putting your eggs into
different baskets. The probability that all of the baskets
break at the same time is low.

34 /
Avoiding Risk

Another way to deal with risk is through

insurance. Insurance is just contingent
consumption.
You can move some of your payoff from the
good state of the world
to the bad state of the world.
Make the bad outcome less bad.

35 /
Avoiding Risk

If your house doesn't burn you keep £

1,000,000 If your house burns down you
get $0
Insurance would be something like buying
a plan that gives you
£ 900,000 if your house doesn't burn
down and £ 100,000 if
your house does burn down.

36 /
Avoiding Risk

Suppose that for every $1 of insurance you buy, you get

$4 if your
house burns down.
The probability your house burning down is .1 and the
probability it doesn't is .9.
By being able to purchase insurance, your expected utility
changes
from the first expression to the second expression.

EU = 0 9U(1, 000, 000) + 0 1(0)

EU = 0 9 * U(1, 000, 000 - x) + 0 1 *
U(4x - x)

To find out exactly how much insurance you would by,

you would maximize this with respect to x.
37 /
Avoiding Risk

If our utility function were U = ln W

EU = 0 9 * ln(1, 000, 000 - x) + 0 1 *

ln(4x - x)

maximise this with respect to x and solve for x

38 /
Avoiding
Risk

dEU 0
= + 0x1 =
dx x - 1,9000, 000
01 09 0
=
x 1, 000, 000 -
x
0 9x = 100, 000 -
0 1x
x = 100, 000

39 /
Avoiding Risk

EXAMPLE
You can insure your bike worth $500
against theft. your bike gets
The probability 2
stolen
For is 1 $1
every . of insurance you buy you get $2 if your bike
is stolen.
If your utility function is U = W 1/2 , how much insurance
should you buy?
What is the intuition behind this result?

40 /
Avoiding Risk

In the previous example, insurance was actuarially fair.

A policy is actuarially fair if the insurance company does
not make any profit.
Expected profit for the insurance company in the previous
example for
every $1 of insurance bought is

E (π) = 1($1) - 1 ($1 - $2) = 0

2 2

41 /
Avoiding Risk

EXAMPLE
Your house burns down with probability 1%.
For every £1 of insurance you buy the insurance company
gives you
£50 back.
Is this actuarially fair?

42 /
Behavioral Economics of Risk

Is this how people actually behave towards risk

though?
Many people make decisions that are inconsistent with
expected utility theory.

43 /
Behavioral Economics of Risk

One common fallacy is the gambler's fallacy

People believe that past events affect current, independent
outcomes. If you flip a fair coin 100 times and they all
come up heads, the probability the next coin is heads is
still .5.
But many people believe that tails is more likely because it
is 11due.11

44 /
Behavioral Economics of Risk

People often overestimate their probability of winning.

In one survey, gamblers estimated their chance of
winning a bet is 45% when the objective probability was
20%.

45 /
Behavioral Economics of Risk

Many people put excessive weight on outcomes they

consider to be certain.
A group of subjects were asked to choose between two
options in an
experiment.

46 /
Behavioral Economics of Risk

Option A: You receive $4,000 with probability .8 and $0 with

probability
.2
Option B: You receive $3,000 with certainty
80% of people choose option B

47 /
Behavioral Economics of Risk

They were then given a separate set of options

Option C: You receive $4,000 with probability .2 and $0 with
probability
.8
Option D: You receive $3,000 with probability .25 and $0 with
probability .75
65% of people choose C

48 /
Behavioral Economics of Risk

These choices are inconsistent

Choosing B over A implies the expected utility of B is
greater than A
U(3, 000) >
08U(4000) Or U(3 000)
> 08
U (4000)

49 /
Behavioral Economics of Risk

Choosing C over D implies that 2U(4000) >

25U(3, 000) U(3 000)
This impliesU(4000) <
08 is inconsistent with expected utility
This
theory

50 /
Behavioral Economics of Risk

The way you present the same lottery can change

people's preferences.
The Avian Flu will kill 600 people, the government
is proposing two
programs to combat it
Program A: 200 people will be saved
Program B: There is a 1/3 probability that 600 people
will be saved and
a 2/3 probability nobody will be saved.
72% opted for program A

51 /
Behavioral Economics of Risk

The Avian Flu will kill 600 people, the government is

proposing two
programs to combat it
Program C: 400 people will die
Program D: There is a 1/3 probability that nobody dies and a
2/3
probability that 600 people will die.
78% opted for program D

52 /
Behavioral Economics of Risk

A and C are the same and B and D are the

same! Framing is a huge issue in
economics.

53 /
Behavioral Economics of Risk

Prospect theory is an alternative approach to decision

making under uncertainty.
Empirically, it is a better match of people's
behaviors. People treat gains and losses differently
in prospect theory.
Small changes are evaluated differently than big
changes.

54 /
Behavioral Economics of Risk

The basic tenants of prospect

theory are
1 Everything is evaluated according to some reference point.

2 People are more sensitive to small gains than to large

gains. For example the difference between $1 and $2 is
larger than $1001 and
$1002.
3

People hate taking losses more than they like taking gains.

55 /
Behavioral Economics of
Risk

56 /
Summary

What is the expected value of a random variable?

What is expected utility?
What are the different attitudes towards risk and who will
take a fair bet?
What is the risk premium?

57 /
Summary

What is fair insurance?

What are inconsistencies with expected utility theory in the
real world?
What is prospect theory?

58 /