Chapter II: Choice Involving Risk

• Chapter Outline
• Introduction
• Expected Income or Wealth
• Expected Utility
• Measuring Risk
• Attitudes toward Risk
• Risk aversion
• Risk lovers
• Risk reduction mechanisms
• Diversification, insurance and information
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 2.1. Introduction/Motivation/
• So far we have assumed that prices, incomes, and
other variables are known with certainty…no risk.
• Actually, many of the choices that people make
involve considerable uncertainty.
• Uncertainty is a fact of life. People face risks every
time they take a shower, walk across the street, or
make an investment.
• Example
– Borrowing to finance consumption, to pay tuition
– Future income can not be known with certainty
– Price of goods may rise beyond expectation
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• The question is:
– how should we take these uncertainties into
account when making major consumption or
investment decisions?
• Since income of the consumer is not known
for sure, we will use expected income as
determinant of consumption
• Similarly, since there are a number of factors
that might affect the occurrence of an events,
it is better to study about expected utility.

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 Risk and uncertainty

• Risk and uncertainty: are they the same?

– Uncertainty can refer to situations in which many outcomes are possible but their likelihoods
are unknown.
– Risk refers to situations in which we can list all possible outcomes, and we know the likelihood
that each outcome will occur.
– In this course, will simplify the discussion by using uncertainty and risk interchangeably.
• Sometimes we must choose how much risk to bear.
• What, for example, should you do with your savings?
– Should you invest your money in something safe ,such as a savings account,
or something riskier but potentially more lucrative, such as the stock
market?
• Another example is the choice of a job or even a career.
– Is it better to work for a large, stable company where job security is good
but the chances for advancement are limited, or to join (or form) a new
venture, which offers less job security but more opportunity for
advancement?
• To answer questions such as these, we must be able to quantify risk so we can
compare the riskiness of alternative choices.
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Describing Risk…..the probability

• To describe risk quantitatively, we need to

know all the possible outcomes of a particular
action and the likelihood that each outcome
will occur
– This takes as to the probability theory
• Probability refers to the likelihood that an
outcome will occur.
number of possible outcomes of an event
p(H) 
Total number of events

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 Examples of probabilities
• Tossing a coin…….(fair gamble)
– P(head)=P(h)=0.5
– P(tail) =P(t)=0.5 or P(t) =1- P(h)
• Tossing a die
– P(odd)=3/6=0.5

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 Expected Income or Wealth
• Expected income or wealth refers to a weighted average of
payoffs resulting from all possible outcomes
– The weights are the probability that each outcome will occur
• The expected value measures the central tendency, that is, the
average payoff.
• Eg1: Suppose that with your original endowment of wealth of Birr
500, you want to buy a lottery of Birr 20 with a prize money of
Birr 10,000
• The two possible payoffs
– 480 + 10,000 = Birr 10,480 …..If she wins
– 500 - 20 =Birr 480,…..if she loses
• Need of Contingent consumption plan
– It is a specification of what will be consumed in each different state of
nature

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 Expected Income=E(Y)
• If the probability that she wins is 0.5, the
expected income ,E(Y) will be
E (Y )  0.5(10,480)  0.5(480)
E (Y )  5240  240
E (Y )  5480
• If we have n number of possible outcomes (V)
with possible probabilities of p1, p2, ….pn,
E (Y )  p1V1  p2V2  ....  pnVn

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 Eg:2

• Suppose you want to buy a share of 10,000 Birr from Dashen Bank
with all your endowments.
• If the Bank makes profit, your return is estimated to be Birr12,000
and if it losses your income will be only Birr 8,000 .Assuming the
success probability of ¾ calculate the expected income from your
investment.
Eg:3
•Assume that Hanna is an employee of a small business
with a monthly gross salary of Birr2000. She earns this with
a probability of 0.9. With a probability of 0.08 her income
increases to Birr 3000 following a bonus payment. If her
income is only Birr 1000 when the company losses, find her
expected income.
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 Utility functions and Probability
….The Expected Utility =E(U)
• Utility under certainty depends on goods consumed
• Under uncertainty, how a person values consumption in
one state as compared to another depends on the
probability that the event in question will actually occur.
• In other words, the rate at which I am willing to
substitute consumption if it rains for consumption if it
doesn’t, should have something to do with how likely I
think it is to rain.
• Hence, the utility function depends on the
probabilities as well as on the consumption levels
• U = U(consumption, probabilities)
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• If the consumption of good 1 is C1 with probability P1
and consumption of good 2 is C2 with probability P2,
then expected utility can be expressed as:
• U = U(C1,C2,P1,P2)
• If the two events are mutually exclusive,P2 = 1-P1
• Examples of expected utility functions
– E(U) = U(C1,C2,P1,P2)= P1C1+C2P2…….Perfect substitutes (U=aX+bY)
– E(U) = U(C1,C2,P1,P2)= C1P1 C2 P2…… Cobb-Douglas Utility fun
• lnU(C1,C2,P1,P2)= P1lnC1+P2lnC2
• This says that utility can be written as a weighted sum
of some functions of consumption in each state, v(c 1)
and v(c2)…the weights are the probabilities
• von Neumann-Morgenstern Utility function
– U(C1,C2,P1,P2)= P1v(C1)+P2v(C2)
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• If one of the states is certain, so that P1=1, then
v(c1) is the utility of a certain consumption in
state 1.
• If P2=1, v(c2) is the utility consumption in state 2
• Thus, P1v(C1)+P2v(C2) represents the average utility, or
the expected utility, of the pattern of
consumption(C1, C2)
• Preferences over certain choices will have the
structure implied by this function
• Why?........the independence assumption

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 The independence assumption of expected utility
• Why do we use expected utility?
• It is reasonable to use it because of the independence assumption.
• Note:
– only one of the two /the many/ outcomes is going to happen
– Either you gain or loss..not both
– Either your house will burn down or it won’t
• Independence between the different outcomes because they must be
consumed differently. Can’t occur together.
• This implies additive behavior of utility function across the different
consumption bundles.
• Eg. Let C0 = current consumption…with current income
C = consumption when investment is profitable
1

C = consumption when investment is not profitable

2

• The relationship between C0 and C1 does not depend on C2.

• The relationship between C0 and C2 does not depend on C1.
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 Measuring Risk: The Variability
• Expected Income E(X)=Pr1(X1)+Pr2X2
• Variability is measured by calculating the differences between actual payoffs
and expected payoffs
• Variability is a measure of the extent to which possible
outcomes of an uncertain events differ.
• Variations are measures of average deviation.
• Average deviation is calculated weighing each deviation by the probability that each
outcome occurs.
• AD=D1Pr1+D2Pr2
• More appropriately, there are two ways of measuring variability:
variance and standard deviation.
• Risk is the possibility that actual income may differ from the expected income and
this is measured using variance.
• Variance is the average of the squares of the deviations of the payoffs
associated with each outcome from their expected values
var iance ( 2 )  Pr1[ X 1  E  X  ]  Pr2 [ X 2  E  X  ]
2 2

• Standard deviation is the square root of the variance ( ) 

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 Measuring Risk: The Variability

• Note: higher deviations(both positive and negative) signals

greater risk.
• Example:1 on variance

TABLE 2.1 Income from Sales Jobs

OUTCOME 1 OUTCOME 2
Probability Income ($) Probability Income ($)

Job 1: Commission .5 20000 .5 10000

Job 2: Fixed Salary .99 15100 .01 5100

● Deviation: Difference between expected payoff and actual payoff.

TABLE 2.2 Deviations from Expected Income ($)

Outcome 1 Deviation Outcome 2 Deviation
Job 1 2000 500 1000 -500
Job 2 1510 10 510 -990

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Variability
● Standard deviation: Is the square root of the weighted
average of the squares of the deviations of the payoffs
associated with each outcome from their expected values.

Table 2.3 Calculating Variance ($)

Weighted Average
Deviation Deviation Deviation Standard
Outcome 1 Squared Outcome 2 Squared Squared Deviation

Job 1 2000 250,000 1000 250,000 250,000 500

Job 2 1510 100 510 980,100 9900 99.5

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Decision Making
• Job 1 is risky.
– It has higher variation as measured by the standard
deviation or the variance.
– The extent of an individual’s risk aversion
depends on the nature of the risk and on the
person’s income.
– Other things 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.
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 Example 2 on variance

• Consider a lottery with three possible outcomes: Br.125 will be

received with probability 0.2, Br.100 with probability 0.3, and Br.50
with probability 0.5.
a. What is the expected value of the lottery?
• The expected value, EV, of the lottery is equal to the sum of the
returns weighted by their probabilities:
• EV = (0.2)(Br125) + (0.3)(Br100) + (0.5)(Br50) = Br.80.
b. What is the variance of the outcomes of the lottery?
• The variance, 2, is the sum of the squared deviations from the
mean, Br.80, weighted by their probabilities:
• 2 = (0.2)(125 - 80)2 + (0.3)(100 - 80)2 + (0.5)(50 - 80)2 = Br973.
c. What would a risk-neutral person pay to play the lottery?
• A risk-neutral person would pay the expected value of the lottery:
Br.80.

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 PREFERENCES TOWARD RISK
There are three different Preferences toward risk
● Risk averse: Condition of preferring a certain income to
a risky income with the same expected value.

● Risk neutral: Condition of being indifferent between a

certain income and an uncertain income with the same
expected value.

● Risk loving: Condition of preferring a risky income

to a certain income with the same expected value.

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 Hot to determine whether a person is risk
averter, lover or neutral
• Given: Initial Endowment of wealth (W)
• He faces a gamble of winning with probability of p
• Steps:
– Step 1: find the two income values
• W + h, if he wins
• W - h, if he losses
– Step 2: find utility of the expected income..UE(W)
– Step 3: find the utility of the expected income from the
variable incomes ….EU(W)
• If UE(W) > EU(W)…….risk averse
• If UE(W) < EU(W)…….risk lover
• If UE(W) = EU(W)…….risk neutral
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 Risk Averter
• Is a person who hates risk
• Is a person who avoids even fair gambles
• He faces a concave utility function
• He has a diminishing marginal utility of money
• E.g. U  f (W ), U  W
– MU=0.5W

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 Risk lover and risk neutral
• A risk lover person wants to take risk.
• The consumer faces a convex utility function
• MU increases
• EU (W) is greater than UE(W).
• He prefers the random distribution of wealth rather than
expected value of wealth
– U=W2
• A risk neutral person does not care about the riskiness of his
wealth at all but only about his expected value.
• A risk lover consumer has a linear utility function
• EU (W) = UE(W).
• MU remains constant
– U =2W
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Figure 2.1
(a) Risk Averter
Risk Aversion, Risk Loving,
and Risk Neutrality

In (a), a consumer’s marginal

utility diminishes as income
increases.

The consumer is risk averse

because she would prefer a
certain income of $20,000
(with a utility of 16) to a
gamble with a .5 probability of
$10,000 and a .5 probability of
$30,000 (and expected utility
of 14).
The expected utility of the
uncertain income is 14—an
average of the utility at point A
(10) and the utility at E (18)—
and is shown by F.
30

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 Figure2.2

Risk Aversion, Risk Loving,

and Risk Neutrality b) Risk c) Risk
In (b), the consumer is Loving Neutral
risk loving:

She would prefer the

same gamble (with
expected utility of 10.5) to
the certain income (with a
utility of 8).

In (c), the consumer is

risk neutral, and
indifferent between
certain and uncertain
events with the same
expected income.

● Expected utility Sum of the utilities associated with all possible

outcomes, weighted by the probability that each outcome will occur.

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 Risk Premium
● Risk premium Maximum amount of money that a risk-averse
person will pay to avoid taking a risk.
Figure 2.3
The risk premium, CF,
measures the amount of
income that an individual
would give up to leave her
indifferent between a risky
choice and a certain one.
Here, the risk premium is
$4000 because a certain
income of $16,000 (at point
C) gives her the same
expected utility (14) as the
uncertain income (a .5
probability of being at point
A and a .5 probability of
being at point E) that has
an expected value of
$20,000.

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 NUMERICAL EXAMPLE
• Suppose that Mr. A is currently earning annual income of Birr
7,000. He now faces an offer of a risky job which would get
either Birr 10,000 with probability of 0.5 or Birr 4,000 otherwise.
Mr. A's utility function is given by the following schedule:
INCOME UTILITY
4000 10
6000 13
7000 15
10000 16
1. Calculate the expected utility of Mr. A from the new job.

2. What would you say about Mr. A’s attitude towards risk? Explain.

3. Calculate the amount that Mr. A pays as Risk premium to insure

his new job.
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 Risk premium
• It is the feature of a risk averse person.
• He is willing to pay some money to avoid the
risk he might face
• The amount of money that an individual is
willing to pay to avoid risk is known as risk
premium
• It is the amount of money that makes the
consumer indifferent between paying the
premium and facing the risk.
• U(E(W) - X) = EU(W)
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 Numerical Examples

1. The utility function of a consumer is given as U=2W 1/2 with an initial

endowment of 60,000Birr. If he is involved in a game of fair gamble which
could lead to a win/loss of 40,000Birr, determine the attitude of this
consumer towards risk.
2. The utility function of a consumer is given as U=2W 4 with an initial
endowment of 50Birr. If he has an equal chance of winning or losing 5Birr,
determine the attitude of this consumer towards risk.
3. The utility function of a consumer is given as U=W 1/2 with an initial
endowment of 900Birr. If he is involved in a game of fair gamble which
could lead to a win/loss of 500Birr, determine how much the consumer is
willing to pay to avoid risk.
4. Utility function is given by 1/3W, initial endowment 600, and he/she has a
90% chance of winning 200 and 10% chance of winning 50
a. Is the consumer risk averse, risk lover or risk neutral
b. Find E (W)
c. Find UE (w)
d. Find EU (W
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 REDUCING RISK
• Three possible measures for reducing risk
• Diversification
– Diversification is a practice of reducing risk by
allocating resources to a variety of activities whose
outcomes are not closely related.
• Insurance payment
• The Value of Information
• value of complete information is difference
between the expected value of a choice when
there is complete information and the
expected value when information is incomplete
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