Micro Economics –ECO402 VU
LESSON 14
CHOICE UNDER UNCERTANTY (Continued)
CHOOSING AMONG RISKY ALTERNATIVES
Assume
• Consumption of a single commodity
• The consumer knows all probabilities
• Payoffs measured in terms of utility
• Utility function given
EXAMPLE
A person is earning $15,000 and receiving 13 units of utility from the job. She is considering a
new, but risky job. She has a .50 chance of increasing her income to $30,000 and a .50
chance of decreasing her income to $10,000. She will evaluate the position by calculating the
expected value (utility) of the resulting income. The expected utility of the new position is the
sum of the utilities associated with all her possible incomes weighted by the probability that
each income will occur.
The expected utility can be written:
E(u) = (1/2)u($10,000) + (1/2)u($30,000)
= 0.5(10) + 0.5(18)
= 14
E(u) of new job is 14 which is greater than the current utility of 13 and therefore preferred.
DIFFERENT PREFERENCES TOWARD RISK
People can be
• Risk averse
• Risk neutral or
• Risk loving
RISK AVERSE:
A person who prefers a certain given income to a risky income with the same expected value.
A person is considered risk averse if they have a diminishing marginal utility of income. The
use of insurance demonstrates risk aversive behavior.
RISK AVERSE: A SCENARIO
A person can have a $20,000 job with 100% probability and receive a utility level of 16. The
person could have a job with a .5 chance of earning $30,000 and a .5 chance of earning
$10,000.
Expected Income = (0.5)($30,000) + (0.5) ($10,000) = $20,000
Expected income from both jobs is the same -- risk averse may choose current job.
The expected utility from the new job is found:
E(u) = (1/2)u ($10,000) + (1/2)u($30,000)
E(u) = (0.5)(10) + (0.5)(18) = 14
E(u) of Job 1 is 16 which is greater than the E(u) of Job 2 which is 14. This individual would
keep their present job since it provides them with more utility than the risky job. They are said
to be risk averse.
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Micro Economics –ECO402 VU
The consumer is risk
Utility Risk Averse E averse because she
would prefer a certain
18 income of $20,000 to a
D gamble with a .5 probability
16 of $10,000 and a .5
C probability of $30,000.
14
13
B
A
10
0 Income ($1,000)
10 15 16 20 30
RISK NEUTRAL
A person is said to be risk neutral if they show no preference between a certain income, and
an uncertain one with the same expected value.
Risk Neutral E
Utility 18
The consumer is risk
neutral and is indifferent
C between certain events
12 and uncertain events
with the same
expected income.
A
6
Income
0 10 20 30
RISK LOVING
A person is said to be risk loving if they show a preference toward an uncertain income over
a certain income with the same expected value.
Examples: Gambling, some criminal activity
Utility Risk Loving
E
1
The consumer is risk
loving because she
would prefer the
gamble
to a certain income.
C
8
A
3
Income
0 10 20 30
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Micro Economics –ECO402 VU
RISK PREMIUM
The risk premium is the amount of money that a risk-averse person would pay to avoid taking
a risk.
RISK PREMIUM: A SCENARIO
The person has a .5 probability of earning $30,000 and a .5 probability of earning $10,000
(expected income = $20,000). The expected utility of these two outcomes can be found:
E(u) = .5(18) + .5(10) = 14
Question: How much would the person pay to avoid risk?
Risk
Premium Here , the risk premium is
Risk Premium $4,000 because a certain
Utility income of $16,000gives the
person the same expected
utility as the uncertain income
that has an expected value of
G $20,000.
20
18 E
C
14 F
A
10
Income ($1,000)
0 10 16 20 30 40
RISK AVERSION AND INCOME
Variability in potential payoffs increases the risk premium.
EXAMPLE:
A job has a .5 probability of paying $40,000 (utility of 20) and a .5 chance of paying 0 (utility of
0). The expected income is still $20,000, but the expected utility falls to 10.
Expected utility = .5u($) + .5u($40,000)
= 0 + .5(20) = 10
The certain income of $20,000 has a utility of 16. If the person is required to take the new
position, their utility will fall by 6.
The risk premium is $10,000 (i.e. they would be willing to give up $10,000 of the $20,000 and
have the same E(u) as the risky job.
Therefore, it can be said that the greater the variability, the greater the risk premium.
INDIFFERENCE CURVE
Indifference curves are combinations of expected income & standard deviation of income that
yield the same utility.
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Micro Economics –ECO402 VU
RISK AVERSION AND INDIFFERENCE CURVES
U3 Highly Risk Averse: An
Expected
Income
increase in standard
U2 deviation requires a
U1 large increase in
income to maintain
satisfaction.
Standard Deviation of Income
Expected
Slightly Risk Averse:
Income
A large increase in standard
deviation requires only a
small increase in income U3
to maintain satisfaction.
U2
U1
Standard Deviation of Income
BUSINESS EXECUTIVES AND THE CHOICE OF RISK
Example
Study of 464 executives found that:
• 20% were risk neutral
• 40% were risk takers
• 20% were risk averse
• 20% did not respond
Those who liked risky situations did so when losses were involved. When risks involved gains
the same, executives opted for less risky situations. The executives made substantial efforts to
reduce or eliminate risk by delaying decisions and collecting more information.
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