Microeconomics II

Lecture 1: Choice under uncertainty

Mohammad Vesal
Graduate School of Management and Economics
Sharif University of Technology

44706
Spring 2020

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Motivation

• Consumers (and producers) often face uncertain outcomes.

• Examples
How many years of schooling to get?
Which job oer to accept?
How long to search for a job?
Any type of decision making that has some implications for
future or depends on future events!
• How do we extend the utility (prot) maximization
framework to the uncertain case?

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Denitions

• C = {c1 , . . . , cN } set of outcomes (e.g. consumption

bundles, monetary payos, etc.)
• Simple lottery: L = (p1 , . . . , pN ) with pn ≥ 0 and
P
n pn =1
pn probability of outcome n
• Compound lottery: L = (L1 , . . . , LK ; α1 , . . . , αK ) where
Lk = (pk1 , . . . , pkN ) is a simple lottery
αk probability of Lk happening
• Reduced lottery: L̃ = (p1 , . . . , pN ) with
pn = α1 p1n + · · · + αK pK
n
We assume indierence between compound lottery and its
reduced lottery.
• Denote the universe of all simple lotteries by L

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Lottery Examples

• Outcomes c1 = 100, c2 = 200, c3 = 0 USD

Would you prefer L = (0.3, 0.3, 0.4) to L = (0.1, 0.4, 0.5)
The simplex representation of simple lotteries.

• Demanding micro course (M), Micro course credited (C),

Demanding stat course (S),
Simple lotteries: L = (0.9, 0.1, 0)L0 = (0, 0.1, 0.9)
Compound lottery: L̃ = (L, L0 ; 0.3, 0.7). What is the
equivalent reduced lottery?

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Outline

Introduction

Expected utility

Risk aversion

Comparing payo distributions

Refs: Ch6 MWG; Ch 11 Varian (1992); Ch 2.4 Jehle and Reny (2011)

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Properties of preferences over lotteries

• Completeness: Could compare any two lotteries.

• Transitivity: If L % L0 and L0 % L00 then L % L00 .
• Continuity: % on L is continuous if ∀L, L0 , L00 ∈ L the two
sets below are closed.
U C(L00 ) = {α ∈ [0, 1] | αL + (1 − α)L0 % L00 }
LC(L00 ) = {α ∈ [0, 1] | L00 % αL + (1 − α)L0 }
Intuition: For any lottery you should be able to nd a
combination of any two (other) lotteries that makes you
indierent.
The three assumptions ensure existence of a utility
function.
I We proved this for the general case in Micro I.
I We would like a simpler representation.

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Independence axiom

• % on L satises the independence axiom if ∀L, L0 , L00 ∈ L

and α ∈ (0, 1) we have
L % L0 ⇔ αL + (1 − α)L00 % αL0 + (1 − α)L00

• Mixing two lotteries with a (common) third lottery does

NOT alter the preference ordering.
• Example: trip (T), trip & accident (AC), stay home (H)
If L = (1, 0, 0) % L0 = (0, 0, 1) then
0.9L + 0.1L00 % 0.9L0 + 0.1L00 where L00 = (0, 1, 0).
• Why do we care about this property? Does it feel natural
to have this?
Allows expected utility form.

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Expected utility form
• The utility function U : L → R has an expected utility form
(vNM) if we could assign (u1 , . . . , uN ) to the N outcomes
in C such that for L = (p1 , . . . , pN ) ∈ L we have
U (L) = p1 u1 + · · · + pN uN

• The utility of the lottery is the weighted sum of utilities

derived from the outcomes.
• Proposition: U has expected utility form i it is linear:

XK K
X
U( α k Lk ) = αk U (Lk )
k=1 k=1

for
PKany lotteries Lk ∈ L and any (α1 , . . . , αK ) ≥ 0 with
k=1 αk = 1.
• Is this a cardinal or an ordinal property?
See proposition 6.B.2 in MWG.
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Existence of the expected utility form

• Proposition: A continuous and rational % dened on space

of lotteries L which satises independence axiom admits an
expected utility representation. (proof not required)
• Intuition:
Consider the case of three outcomes
Lottery space is the three dimensional simplex
3
∆ = {p ∈ R+ | p1 + p2 + p3 = 1}

Under independence the indierence curves must be parallel

lines.
straight

• Importance of expected utility form

Analytical ease
As a guide to introspection

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Issues with the independence axiom

• The central assumption in the expected utility theorem is

independence.
• But how reasonable is this?
• Several experiments show violations of this assumption.
Allais paradox
Machina's paradox

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Allais Paradox

• Three monetary prizes: 2,500,000$, 500,000$, and 0$

• Which lottery do you prefer?
L1 = (0, 1, 0) vs. L01 = (0.1, 0.89, 0.01)
L2 = (0, 0.11, 0.89) vs. L02 = (0.1, 0, 0.9)
• L1  L01 and L02  L2
But this is inconsistent with vNM expected utility.
• How do we handle this violation of the independence
axiom?

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Outline

Introduction

Expected utility

Risk aversion

Comparing payo distributions

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Money lotteries

• Suppose outcomes are scalars (money, consumption, etc.):

C = R+
• A lottery is a cumulative distribution function:
F (x) : R+ → [0, 1]
probability that the outcome is less than or equal to x.
• Preferences

admit expected utility form
U (F ) = u(x)dF (x)
where u(x) is the utility of getting the certian outcome x
(Bernoulli utility)
assume u(x) strictly increasing and continuous

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Risk attitudes
• Risk averse i ∀F
  
u(x)dF (x) ≤ u xdF (x)

utility derived from the lottery is less than or equal to

utility derived from receiving the average outcome with
certainty.
• Risk neutral i ∀F
  
u(x)dF (x) = u xdF (x)

• Risk loving i ∀F
  
u(x)dF (x) ≥ u xdF (x)

• Could dene strict risk averse (loving) preferences.

• Risk aversion is equivalent to concavity of u(x) [Jensen's
inequality]
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Certainty equivalent and probability premium

• c(F, u) is the certain amount that gives a utility equal to

that of the lottery F

u (c(F, u)) = u(x)dF (x)

• π(x, , u) is the probability premium dened as

   
1 1
u(x) = + π(x, , u) u (x + )+ − π(x, , u) u (x − )
2 2

how much should we favor the high reward to make two

uncertain (high and low) outcomes equivalent to their
average?

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Proposition

• The following properties are equivalent

risk aversion
concavity of u(x) [Bernoulli utility]
I decreasing marginal utility


c(F, u) ≤ xdF (x) for all F
π(x, , u) > 0 for all x, 

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Example: Insurance
• Strictly risk averse consumer with initial wealth w
with probability π the consumer incurs a loss of D
• Will there be demand for insurance?
• What is insurance?
purchasing α units of insurance (at a price of q ) will pay α
units of wealth in case of incurring the loss
• Expected wealth with insurance

(1 − π) (w − αq) + π (w − αq − D + α)

• Choose α to maximize expected utility

max (1 − π)u (w − αq) + πu (w − αq − D + α)

α≥0

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Example: Demand for a risky asset

• Safe asset: returns 1 dollar per dollar invested

• Risky asset: returns z dollars per dollar invested

z ∼ F (z)
• Will there be any demand for the risky asset if we have a
risk averse investor?

Need to assume zdF (z) > 1. Interpretation?
• Investor chooses a portfolio of the safe and risky asset

max u(αz + β)dF (z)
α,β≥0
s.t. α+β =w

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Measuring degree of risk aversion

• Coecient of absolute risk aversion (CARA)

u00 (x)
rA (x) = −
u0 (x)
• Coecient of relative risk aversion (CRRA)

xu00 (x)
rr (x) = −
u0 (x)

• What is rA (x) and rr (x) for u(x) = 1 − e−αx ?

• What is rA (x) and rr (x) for u(x) = 1−ρ ?
x1−ρ

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Outline

Introduction

Expected utility

Risk aversion

Comparing payo distributions

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First order stochastic dominance

• Assume C = [a, b]
• F (x)rst-order stochastically dominates G(x) if for every
non-decreasing u
 b  b
u(x)dF (x) ≥ u(x)dG(x)
a a

• F (x)rst-order stochastically dominates G(x) i

F (x) ≤ G(x) for all x.

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Example

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Second order stochastic dominance

• Consider F and G with the same expected values (means)

• F (x) second-order stochastically dominates G(x) if for
every non-decreasing concave u we have
 b  b
u(x)dF (x) ≥ u(x)dG(x)
a a

• This is about risk when average payos are the same.

• If x ∼ F (x) and z has zero mean conditional on x then we
call w = x + z a mean-preserving spread of F.
• The three statements below are equivalent
F (x) second-order stochastically dominates G(x)

xis a mean-preserving
G
x spread of F
a
F (t)dt ≤ a
G(t)dt for all x ∈ [a, b]

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Example

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Summary

• During this lecture we learned

concept of a lottery
conditions required for existence of expected utility form
meaning of risk aversion, certainty equivalent
stochastic dominance

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