Risk and Uncertainty

Instructor: Br Tattwachaitanya
July—December, 2023

Reference: 1.Pindyck-Rubinfeld
2. Mankiw

Copyright © 2013 Pearson Education, Inc. • Microeconomics • Pindyck/Rubinfeld, 8e. 1 of 45

 Risk Aversion
• Most people are risk averse – they dislike uncertainty.
• Example: You are offered the following gamble.
Toss a fair coin.
– If heads, you win $1000.
– If tails, you lose $1000.
Should you take this gamble?
• If you are risk averse, the pain of losing $1000 would
exceed the pleasure of winning $1000,
and both outcomes are equally likely,
so you should not take this gamble.

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 Preferences Toward Risk
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’ll 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 measure payoffs in terms of utility rather than dollars.
In our example, a consumer has an income of $15,000 and is considering a new but
risky sales job that will either double her income to $30,000 or cause it to fall to
$10,000. Each possibility has a probability of .5.
To evaluate the new job, she can calculate the expected value of the resulting income.
Because we are measuring value in terms of her utility, we must calculate the expected
utility E(u) that she can obtain.
● expected utility Sum of the utilities associated with all possible outcomes, weighted
by the probability that each outcome will occur.

𝐸 𝑢 = 1 2 𝑢 $10,000 + 1 2 𝑢 $30,000 = 0.5 10 + 0.5 18 = 14

The risky new job is thus preferred to the original job because the expected
utility of 14 is greater than the original utility of 13.5
 The Utility Function and Risk Aversion
Utility
Utility gain from
winning $1000
Utility loss
from losing
$1000

Because of diminishing
marginal utility,
a $1000 loss reduces utility Wealth
more than a $1000 gain –1000 +1000
increases it.

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Different Preferences Toward Risk
Figure 5.3 (1 of 2)
RISK AVERSE, RISK LOVING, AND RISK NEUTRAL
● risk averse Condition of preferring a certain income
to a risky income with the same expected value.
People differ in their preferences
toward risk.
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.
Figure 5.3 (2 of 2)
RISK AVERSE, RISK LOVING, AND RISK NEUTRAL
● risk loving Condition of preferring a
risky income to a certain income with the
same expected value.
In (b), the consumer is risk loving: She would
prefer the same gamble (with expected utility of
10.5) to the certain income (with a utility of 8).
● risk neutral Condition of preferring a
risky income to a certain income with the
same expected value.
In (c) is risk neutral and indifferent
between certain and uncertain events with
the same expected income.
RISK PREMIUM
● risk premium Maximum amount of money that a risk-averse
person will pay to avoid taking a risk.

Figure 5.4
RISK PREMIUM
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.
 Managing Risk With Insurance

• How insurance works:

A person facing a risk pays a fee to the insurance
company, which in return accepts
part or all of the risk.
• Insurance allows risks to be pooled,
and can make risk averse people better off:
E.g., it is easier for 10,000 people to each bear
1/10,000 of the risk of a house burning down
than for one person to bear the entire risk alone.

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THE LAW OF LARGE NUMBERS
Insurance companies are firms that offer insurance because they know that
when they sell a large number of policies, they face relatively little risk. The
ability to avoid risk by operating on a large scale is based on the law of large
numbers, which tells us that although single events may be random and largely
unpredictable, the average outcome of many similar events can be predicted.

ACTUARIAL FAIRNESS
When the insurance premium is equal to the expected payout, as in the
example above, we say that the insurance is actuarially fair.

● actuarially fair Characterizing a situation in which an insurance

premium is equal to the expected payout.
 Two Problems in Insurance Markets
1. Adverse selection:
A high-risk person benefits more from
insurance, so is more likely to purchase it.
2. Moral hazard:
People with insurance have less incentive to
avoid risky behavior.
Insurance companies cannot fully guard against
these problems, so they must charge higher prices.
As a result, low-risk people sometimes forego
insurance and lose the benefits of risk-pooling.

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 Measuring Risk

• We can measure risk of an asset with the

standard deviation, a statistic that measures a
variable’s volatility – how likely it is to
fluctuate.
• The higher the standard deviation of the
asset’s return, the greater the risk.

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 Reducing Risk Through Diversification
• Diversification reduces risk by replacing a
single risk with a large number of smaller,
unrelated risks.
• A diversified portfolio contains assets whose
returns are not strongly related:
– Some assets will realize high returns,
others low returns.
– The high and low returns average out,
so the portfolio is likely to earn
an intermediate return more consistently
than any of the assets it contains.

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 Reducing Risk Through Diversification
• Diversification can reduce firm-specific risk,
which affects only a single company.
• Diversification cannot reduce market risk,
which affects all companies in the stock
market.

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 Reducing Risk Through Diversification
50 Increasing the number of
stocks reduces firm-
Standard dev of
portfolio return

40 specific risk.
30

20 But
market
10 risk
remains.
0
0 10 20 30 40
# of stocks in portfolio
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 The Tradeoff Between Risk and Return
• Tradeoff:
Riskier assets pay a higher return, on average,
to compensate for the extra risk of holding them.
• E.g., over past 200 years, average real return on stocks,
8%. On short-term govt bonds, 3%.

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 The Tradeoff Between Risk and Return
• Example:
Suppose you are dividing your portfolio between two
asset classes.
– A diversified group of risky stocks:
average return = 8%, standard dev. = 20%
– A safe asset:
return = 3%, standard dev. = 0%
• The risk and return on the portfolio depends on the
percentage of each asset class in the portfolio…

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 The Tradeoff Between Risk and Return
Increasing
the share of
stocks in the
portfolio
increases
the average
return but
also the risk.

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