Chapter 2 Choice involving risk

Chapter 2
2. Choice Under Risk
2.1 INTRODUCTION
So far we have been implicitly assuming that information on prices and income is known by the
consumer (decision maker). But many of the choice problems that the consumers face entail
uncertainty about the possible outcomes of income, price and other variables. 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.
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, i.e., Probabilistic information.
2.2 PROBABILITIES
Even though you don’t know what the value of uncertain investment 1 (for example investment in
stock) will be next year, you can still describe what it might be. In particular, suppose you know
that over the next year, one of three things will happen to your $100 investment:
• Its value could go up by 20 percent to $120 (outcome A).
• Its value could remain the same (outcome B).
• Its value could fall by 20 percent to $80 (outcome C).
Your investment in the stock is an example of an uncertain event. In real life, these kinds of
uncertain events are like a game of chance. In microeconomics, we use the term lottery to
describe any event—an investment in a stock, the outcome of a college football game, the spin of
a roulette wheel—for which the outcome is uncertain.
The lottery described above has three possible outcomes: A, B, and C. The probability of a
particular outcome of a lottery is the likelihood that this outcome will occur. If there is a 3 in 10
chance that outcome A will occur, we say that the probability of A is 3/10, or 0.30. If outcome B
has a 4 in 10 chance of occurring, we say that the probability of B is 4/10, or 0.40. And if there is
a 3 in 10 chance that outcome C will occur, the probability of C is 0.30. The probability
1
We usually use the term pay off to imply the value associated with a possible outcome.

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distribution of the lottery depicts all possible outcomes in the lottery and their associated
probabilities.
For any lottery, the probabilities of the possible outcomes have two important properties:
• The probability of any particular outcome is between 0 and 1.
• The sum of the probabilities of all possible outcomes is equal to 1.
Where do probabilities and probability distributions come from? Some probabilities result from
laws of nature. For example, if you toss a coin, the probability that it will come up heads is 0.50.
You can verify this by flipping a coin over and over again. With a large enough number of flips
(100 or 200), the proportion of heads will be about 50 percent.
However, not all risky events are like coin flips. In many cases, it might be difficult to deduce
the probabilities of particular outcomes. For example, how would you really know whether your
stock has a 0.30 chance of going up by 20 percent? Your assessment reflects not immutable laws
of nature but a subjective belief about how events are likely to unfold. Probabilities that reflect
subjective beliefs about risky events are called subjective probabilities. Subjective probabilities
must also obey the two properties of probability just described. However, different decision
makers might have different beliefs about the probabilities of possible outcomes of a given risky
event. For example, an investor more optimistic than you might believe the following:
Probability of A = 0.50 (there is a 5 in 10 chance that the stock’s value will go up by 20
percent).
Probability of B = 0.30 (there is a 3 in 10 chance that the stock’s value will stay the
same).
Probability of C = 0.20 (there is a 2 in 10 chance that the stock’s value will go down by
20 percent).
These subjective probabilities differ from yours, but they still obey the two basic laws of
probability: each is between 0 and 1, and they add up to 1.
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. However, under conditions of
uncertainty some additional structure, called probability, needs to be added to the choice
problem.

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Thus the utility function is defined based on the consumption levels under different states as well
as the respective probabilities of the different states. Let C1 & C2 represent consumptions in
Π1 Π2
two states and let & be their respective probabilities, then we can write our utility
Π1 Π2
function for the different consumption states as U (C1, C2, & ).

2.3 EXPECTED UTILITY (Expected Value)

Expected Value – is outcome expected on average. It is the weighted average of all possible
outcomes of an event (the weights being probabilities).
Example: Take an event that can result in two possible outcomes; X1 = Outcome 1and X2 =
Π1 Π2
Outcome 2. Let is the probability of outcome 1 and is the probability of outcome 2,
then the expected value (E(X))of the event is given by:
E( X)=X 1+ X 2.
The formalization of consumer choice theory under uncertainty was initially pioneered by Von
Neumann and Oskar Morgenstern. The central premise of the theory is that consumer’s choose
the alternative with the highest expected utility rather than the highest expected value.
Variability
Variability – refers to the extent 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.
n
Variance=σ =∑ π i ( X i− X́ )2
2

i=1

σ 2=π 1 ¿ ¿+…+ π n ¿ ¿
Where π i stands for the probability associated with outcome i, X i refers to the value of outcome
i, X́ stands for the mean value of outcome X i s , and σ 2 (read as sigma squared) denotes variance.
To see why variability is important consider the following example. Suppose you are choosing
between two part time sales jobs that have the same expected income of 1500 birr.
 The first job is based entirely on commission; i.e., the income earned depends on how
much you sell. There are two equally likely payoffs for this job: 2000 birr for a successful
sales effort and1000 birr for one that is less successful.

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 The second job is salaried. It is very likely (0.99 probability) that you will earn 1510 birr,
but there is 0.01 probability that the company will go out of business, in which case you
would earn 510 birr in separation pay.
Note that these two jobs have the same expected income:
For job 1: Expected Income ¿ 0.5(2000 birr )+ 0.5(1000 birr)=1500birr
For job 2: Expected Income ¿ 0.99(1510 birr )+ 0.01(510 birr)=1500 birr
However, the variability of the two job offers is different. We measure variability by recognizing
that large differences between actual and expected payoffs (whether positive or negative) imply
greater risk. I.e., if the variability associated with a certain event is high, it implies that choice of
this event entails higher risk and vice versa. Let’s take some time to calculate the variability of
payoffs for the two job offers.
Outcome 1 Outcome 2 Expected Income
(Birr)
Income probability Income probability
Job 1 2000 0.5 1000 0.5 1500
Job 2 1510 0.99 510 0.01 1500

The variability for the two jobs can be calculated by the using the formula for variance:

σ 2=π 1 ¿ ¿

Vari a n ce job1 =σ 2J 1=0.5[2000−1500]2 +0.5 [1000−1500]2

2
σ 2J 1=0.5 [ 500 ] +0.5 [−500]2=250,00

Vari a n ce job2 =σ 2J 2=0.99[1510−1500]2 +0.5 [510−1500]2

2
δ 2J 2=0.99 [ 10 ] + 0.5[−990]2 =9900

We can also measure variability by using the standard deviation (SD) formula. SD is the
square root of variance.

SD=σ = σ 2=¿ √ π 1 ¿ ¿ ¿ ¿
√
SD job 1=σ j 1=√ π 1 ¿ ¿ ¿

SD job 2=σ j 2=√ π 1 ¿ ¿ ¿

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Thus, job 1 entails higher risk because the variability associated with its payoffs are greater
than job 2 (i.e., 500 > 99.5). But, this does not mean that rational decision makers will choose
job 1 to job 2. The choice of alternatives with different risk levels depends on the attitudes or
preferences that individuals have towards risk.

2.4 INDIVIDUAL’S PREFERENCES TOWARDS RISK

We used a job example to show how people might evaluate risky outcomes, but the principles
apply equally well to other choices. In this section, we concentrate on consumer choices
generally and on the utility that consumers obtain from choosing among risky alternatives. To
simplify things, we will consider the utility that a consumer gets from his or her income or, more
appropriately the market basket that the consumer’s income can buy. We now measure payoffs
in terms of utilities rather that money.
a. 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 a 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.
Figure 2.1 illustrates how we can describe one women’s preference towards risk. The curve U,
which gives her utility function, tells us the utility she can attain for each level of income
(income is measure on thousands of birr on the horizontal axis). The level of utility increases
from 10 to 16 to 18 as income increases from 10,000 birr to 20,000 birr to 30,000 birr. However,
note that her marginal utility is diminishing, falling from 10 to 6 when income increases from
10,000 to 20,000 and falling from 6 to 2 when income increases from 20,000 to 30,000.
Now suppose the women currently has 20,000 birr and she is considering to take a new but risky
job that will increase her wealth to 30,000 if it succeeds but will reduce her wealth to 10,000 if it
fails. Each success and failure has equal probability of 0.5. As figure 2.1 shows, the utility level
associated with 10,000 birr is 10 (at point A) and the utility level associated with an income of
30,000 birr is 18 at point E. The risk job must be compared with the current 20,000 birr job for
which the utility is 16 at point B.
To evaluate the new job, she can calculate the expected value of the resulting income. Because
we are measuring value in terms of the women’s utility, me must calculate the expected utility

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E(U) that she can obtain. The expected utility is the sum of the utilities associated with all
possible outcomes, weighted by the probability of each outcome. For our example, the expected
utility of the women is found as follows:
E(Utility )=0.5 ×Utility of (10,000 birr ) +0.5 ×Uility of (30,00 birr )
¿ 0.5(10)+0.5(18)
E(U )=14

UTILITY

C U
u (30)=18 B
u (20)=16
5u(10)+.5u(30)=14

u(10) =10 A

10 20 30 WEALTH

Figure 2.1:Risk Aversion. For a risk-averse consumer the utility of

the expected value of wealth, u(20), is greater than the expected
utility of wealth, .5u(10)+.5u(30).

The women decides to take or not to take the new job by comparing the utility associated
with the original job (i,e., U(20)) with the expected utility of the new job (i.e., E(U)). The
woman prefers the original job to the new risky job because the expected utility of the new
job (14) is less than the utility from her original job (16). I.e., U(20,000) > E(U).
Note, however, that the expected incomes associated with the original job and the new risky
jobs are equal. That is,
E ( Value of original Job )=20,000 birr ×1=20,000 birr
Since her original job has only one possibility (20,000) with a probability of 1.
E ( Value of new job )=0.5 ×(30 , 000 birr)+0.5 × ( 10,000 birr )=20 , 000

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Thus, the woman is risk averse in that she prefers a certain income to a risky income with
the same expected value.
A risk averse consumer has a concave utility curve. This implies that the slope of a utility curve
gets flatter and 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.
b. Risk Loving
A consumer is Risk Loving if he/she prefers a risk income to a certain income with the same
expected value. Risk loving is a situation where the utility from a given amount of wealth
(income) is less than the expected utility.
We can illustrate the preferences of a risk loving person by taking the earlier example where a
woman was confronted with a new job. In this case, we will modify the utility she obtains from
different levels of income in such a way that her marginal utility increases as her income
increase. Let’s suppose that the job opportunities and their associated probabilities stay the same
but let’s assume that the utility from income changes in the manner depicted in figure 2.2. In this
case, the utility of 10,000 birr will be 3, the utility from 20,000 birr will be 8 and the utility from
30,000 birr will be 18. Marginal utility increases from 3 to 5 to 10 as income increases from 10
to 20 to 30 thousands of birr.

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 .5u(10)+.5u(30
Chapter 2 Choice involving risk

u(30)=18
u(20) =8
u(10)=3

Utility
Figure 2.1: Risk Loving

1 u (10)   2 u (30)
1 1
 3  (18)
2 2
1.5  9  10.5
U (wealth)

10 20 30 Wealth

As figure 2.2 shows, the expected utility from the new job is E(U)= 10.5. The utility from the
original job is U(20,000 birr)= 8. Thus, 10.5 > 8 and the consumer prefers to take the new risky
job.
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 is, the more risk averse the consumer is. In contrast, the more convex
the utility curve, the more risk lover the consumer is.
c. Risk Neutral
If a person is indifferent between a given amount of wealth with certainty and uncertain income
with the same expected value the person is said to be risk neutral. As shown in figure 2.3, a risk
neutral consumer has straight line utility curve showing that the marginal utility is constant for
the risk neutral consumer. Given the utility from income as: U(10)= 6, U(20) =12 and U(30) =
18, the risk neutral consumer is will be indifferent between the original job and the new risky
job. This is because U(20,000 birr) = E(U). The expected utility from the new job is:
0.5U(10)*0.5U(30) = 0.5*6 + 0.5*18= 3 + 9 =12.

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U (wealth)
Utility

Figure 2.3: Risk Neutral

u(30)=18

U(20)=12

u(10)=6

5 10 15 Wealth

Risk Premium
What do risk averse people do in order to minimize their risk?
The risk premium is the amount of money that a risk-averse person would pay to avoid
taking a risk. The magnitude of the risk premium depends in general on the risky alternatives
that the person faces. To determine the risk premium, we have reproduced the utility function
of Figure 2.1 in Figure 2.4. Recall that an expected utility of 14 is achieved by a woman who
is going to take a risky job with an expected income of $20,000. This is shown graphically by
drawing a horizontal line to the vertical axis from point F, which bisects straight line AE
(thus representing an average of $10,000 and $30,000). But the utility level of 14 can also be
achieved if the woman has a certain income of $16,000, as shown by dropping a vertical line
from point C. Thus, the risk premium of $4000, given by line segment CF, is the amount of
income ($20,000 minus $16,(00) she would give up to leave her indifferent between the risky
job and the safe one. How risk averse a person is depends on the nature of the risk and on the
person's income.

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Figure 2.4: Risk Premium

The risk premium, CF,
measures the amount of
income 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
gives her the same expected
utility (14) as the uncertain
income that has an expected
value of $20,000.

.
Generally, risk-averse people prefer risks involving a smaller variability of outcomes. We
saw that when there are two outcomes, an income of $10,000 and an income of $30,000, the
risk premium is $4000. Now consider a second risky job, involving a .5 probability of
receiving an income of$40,000 and a utility level of 20 and a .5 probability of getting an
income of $0. The expected income is again $20,000, but the expected utility is only 10:
Expected utility = .5u($O) + .5u($40,OOO) = 0 + .5(20) = 10
Since the utility of having a certain income of $20/000 is 16, the woman loses 6 units of
utility if she is required to accept the job. The risk premium in this case is equal to $10,000
because the utility of a certain income of $10,000 is 10. She can afford to give up $10,000 of
her $20,000 expected income to have the certain income of $10,000 and will have the same
level of expected utility. Thus the greater the variability, the more a person is willing to pay
to avoid the risky situation.
2.5 MINIMIZING RISK
Three ways that consumers use to reduce risks are: Diversification, Purchase of Insurance,
obtaining more information and Risk Spreading.
a. 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.

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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:
1) If the person puts the whole investment in one of the companies say heater.
Outcomes Probabilities
Cold 200,000 (200X1000) .5
Hot 50,000 (50X1000) .5
His expected income from his investment in the heater company will be:
200,000*0.5 + 50,000 * 0.5 = 125,000 birr
However, since the weather condition will be either hot or cold but not both, the person can
either earn 200,000 or 50,000 birr with probability of 0.5 for each. Thus, there is a great deal of
risk involved in this kind of investment.
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)
If the person diversifies his investment in both companies, whatever the weather condition is, he
will get a certain income of 125,000 birr involving no risk. Thus, the person has completely
eliminated risk through diversification.
b. Buying Insurance
To illustrate why people buy insurance policies, let’s imagine that you are risk averse and
you have just purchased a new car. If all goes well—if the car works as planned and if you

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don’t have an accident— you will have $50,000 of income available for consumption of the
goods and services that you would typically purchase over the course of a year. If, however,
you have an accident and you are uninsured, you would expect to pay $10,000 for repairs.
This would leave just $40,000 available for consumption of other goods and services. Let’s
suppose that the probability of your having an accident is 0.05, so the probability of your not
having an accident is 0.95. Thus, if you remain uninsured, you face a lottery: a 5 percent
chance of $40,000 in disposable income and a 95 percent chance of $50,000 in disposable
income.
Let’s now suppose that you have the opportunity to buy $10,000 worth of annual insurance
coverage at a total cost of $500 per year ($500 is called the insurance premium). Under this
policy, the insurance company agrees to pay for up to $10,000 worth of repairs on your
automobile in the event that you have an accident. This insurance policy has two notable
features. First, it provides full coverage (up to $10,000) for any damage you might suffer if
you have an accident.5 Second, it is a fairly priced insurance policy. A fairly priced insurance
policy is one in which the insurance premium is equal to the expected value of the promised
insurance payment. Because there is a 5 percent chance that the policy will pay $10,000 and
a 95 percent chance that it will pay nothing, the expected value of the promised insurance
payment is (0.05 * $10,000) + (0.95 * 0) = $500. If the insurance company sold this policy to
many individuals with an accident risk that is similar to yours, it would expect to break even
on these policies.
We can use the logic of risk aversion to show that you should jump at the chance to buy this
policy. If you buy the policy, you get
• $50,000 - $500 = $49,500, if you do not have an accident
• $50,000 - $500 -$10,000 +$10,000 = $49,500, if you have an accident
The insurance policy thus eliminates all of your risk and allows you to consume $49,500
worth of goods and services no matter what. If you do not buy the policy, you get
• $50,000 if you do not have an accident
• $40,000 if you have an accident
The expected value of your consumption in this case is
(0.95 * $50,000) + (0.05 *40,000) =$49,500.

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Thus, the expected value of your consumption if you do not buy insurance is equal to the
certain value of your consumption if you do buy insurance. Because a risk-averse decision
maker prefers a sure thing to a lottery with the same expected value, you will prefer to buy a
fair insurance policy that provides full coverage against a loss rather than buy no insurance at
all.
c. 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.
Example: Consider a situation of an individual who had Br.3500 and faced a 0.1 probability of
Birr 10,000 loss. Suppose that there were 1000 such individuals. On 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.
d. Information
The decisions that consumers make when the outcomes are uncertain are based on limited
information. If more information were available, consumers would make better predictions and
reduce risk. Because information is available commodity, people will pay for it. The value of
complete information is the differences between the expected value of a choice when there is a
complete information and the expected value when the information is imperfect.

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