UNCERTAINTY

NGUYEN BICH DIEP, PhD

DESCRIBING RISKS

• Probability: the likelihood that a given outcome will occur.

• The expected value associated with an uncertain situation is a
weighted average of the payoffs or values associated with all possible
outcomes.
• If a business face a probability of 50% that it will succeed and generate a profit
of $100 million, and a probability of 50% that it will fail and incur a loss of $40
million, then the expected profit of this business is:
100 x 0.5 + (- 40) x 0.5 = 30 ($ million)
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• Think of a lottery.
• Win $90 with p = 1/2, and win $0 with p = 1/2.
• U($90) = 12, U($0) = 2
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• Expected monetary value of the lottery is:

1 1
EM =  $90 +  $0 = $45.
2 2
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• Expected utility is:

1 1
EU =  U($90) +  U($0)
2 2
1 1
=  12 +  2 = 7.
2 2
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• EU = 7 and EM = $45
• U($45) > 7  $45 for sure is preferred to the lottery  risk-averse
• U($45) < 7  the lottery is preferred to $45 for sure  risk-loving
• U($45) = 7  the lottery is preferred equally to $45 for sure  risk-
neutral
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U($45) > EU  risk-averse
12
U($45)
MU declines as wealth
EU=7 rises.

2
Wealth
$0 $45 $90
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U($45) < EU  risk-loving

12

MU rises as wealth
EU=7 rises.
U($45)
2
Wealth
$0 $45 $90
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U($45) = EU  risk-neutral
12

U($45)= MU constant as wealth

EU=7 rises.

2
Wealth
$0 $45 $90
EXERCISE 3

• A risk-averse individual is offered a choice between a gamble that

pays $1000 with a probability of 25% and $100 with a probability of
75%, or a payment of $325. Which would he choose?
• What if the payment was $320?