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Lecture Notes 4:
Uncertainty and Behavioral
Economics

Prof. Geunyong Park

 Outline
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➢ Describing uncertainty and risk

➢ Probability and expected value
➢ Preferences toward risk
➢ Reducing risk

➢ Behavioral economics
➢ Subjective probability
➢ Reference points
➢ Status quo bias
➢ Loss aversion
➢ Framing effects
➢ Anchoring effects
➢ Nudging
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Part I
Uncertainty and Risk
 Example: stocks or real estate?
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➢ Which provides the better long-term return on investment: stocks, or real

estate? Which one do you prefer?
 Introduction of Uncertainty
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➢ Decisions are made daily. Most choices are obvious.

➢ What should you eat for dinner?

➢ Should I come to school or stay at home?

➢ Sometimes, people encounter decisions that may involve a variety of

uncertainty.
➢ Risking your full-time job to run a small business

➢ Choosing NUS Business School or US Business Schools

➢ What should we take into account when making decisions then?

 The Ways to Compare and Choose
Among Risky Alternatives
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➢ Quantifying risk
➢ Examining people’s preferences toward risk
➢ In some situations, people must choose the amount of risk they wish to
bear.
➢ Seeing how people can sometimes reduce or eliminate risk.
 Some Preliminary Concepts
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➢ Probability Likelihood that a given outcome will occur.

➢ Expected value Probability-weighted average of the payoffs associated

with all possible outcomes.
With two possible outcomes, the expected value is
E(X) = Pr1X1 + Pr2X2
When there are n possible outcomes, the expected value becomes
E(X) = Pr1X1 + Pr2X2 + . . . + PrnXn
 How would you rank the following options?
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Lottery A: receive $10 with probability of 0.5 or pay $10 with probability of 0.5
Lottery B: receive $12 with probability of 0.5 or pay $12 with probability of 0.5
Lottery C: receive $8 with probability of 0.5 or pay $8 with probability of 0.5

➢ The expected values are the same.

➢ Do you indifferent between them?
 Variability (Standard Deviation)
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➢ standard deviation Square root of the weighted average of the squares of

the deviations of the payoffs associated with each outcome from their
expected values
Lottery A: receive $10 with probability of 0.5 or pay $10 with probability of 0.5
Lottery C: receive $8 with probability of 0.5 or pay $8 with probability of 0.5

EV of Lottery A: 0.5 × 10 + 0.5 × −10 = 0

SD of Lottery A: 0.5 × (10 − 0)2 +0.5 × (−10 − 0)2 = 10

EV of Lottery C: 0.5 × 8 + 0.5 × −8 = 0

SD of Lottery C: 0.5 × (8 − 0)2 +0.5 × (−8 − 0)2 = 8

 ‘St. Petersburg Paradox’ (Bernoulli 1738)
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Toss a coin until the first head comes up.

When the first head comes up at the nth toss, you are paid $2n .
(Once the first head comes out, the game is over.)

➢ How much are you willing to pay to play the game? $1? $10?
$1,000,000?
 EV of the St. Petersburg Coin Flip
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n 1 2 3 …… n …...

Winning $ 2 22 23 …… 2n ……

prob. (1/2) (1/2)2 (1/2)3 …… (1/2)n ……

EV = 2(1/2) + 22(1/2)2 + 23(1/2)3 + … + 2n(1/2)n + …

= 1+1+1+…
=∞

Would you pay as much as you can to play this game?

 Expected Utility
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➢ Expected Utility Sum of the utilities 𝑈 𝑋 associated with all possible

outcomes 𝑋𝑖 , weighted by the probability 𝑃𝑟𝑖 that each outcome will occur.

𝐸𝑈 𝑋 = ෍ 𝑈 𝑋𝑖 𝑃𝑟𝑖
𝑖=1

- Example:
The satisfaction we would get from $2 million isn’t necessarily two times of –
in fact not that much greater than - the satisfaction we’d get from $1
million.
 Preference Towards Risk
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➢ An individual who is risk averse

prefers a certain given income to a
risky income with the same expected
value.

➢ A certain income of $20,000 better

than an income of $30,000 with
P=0.5 and an income of $10,000
with P=0.5
(16 > 18 × 0.5 + 10 × (0.5)=14)

➢ Risk aversion is the most common

attitude toward risk.
 Preference Towards Risk
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➢ An individual who is risk neutral is

indifferent between a certain income
and an uncertain income with the
same expected value.

➢ A certain income of $20,000

indifferent with an income of
$30,000 with P=0.5 and an income
of $10,000 with P=0.5
(12 = 18 × 0.5 + 6 × 0.5 )

➢ The marginal utility of income is

constant for a risk-neutral person.
 Preference Towards Risk
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➢ An individual who is risk loving

prefers an uncertain income to a
certain one, even if the expected
value of the uncertain income is less
than that of the certain income.

➢ A certain income of $20,000 worse

than an income of $30,000 with
P=0.5 and an income of $10,000
with P=0.5
(8 < 18 × 0.5 + 3 × 0.5 = 10.5)
 Risk Premium
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➢ Risk premium
Maximum amount of money that a risk-averse person will pay to avoid
taking a risk.

The risk premium measures the amount of income that an individual would
give up to leave her indifferent between a risky choice and a certain
one.
 Reducing Risk
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➢ Diversification
Allocating your resources to a variety of activities whose outcomes are not
closely related.
➢ Recall the old saying, ‘ Don’t put all your eggs in one basket’

➢ The stock market Even with a diversified portfolio of stocks, you still
face some risk.

➢ Insurance
Risk-averse people buy enough insurance to recover fully from any financial
losses they might suffer.
➢ The law of large numbers Although single events may be random and
largely unpredictable, the average outcome of many similar events can
be predicted.
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Part II
Behavioral Economics
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Behavioral Economics
➢ The assumption of rationality is the key feature in Economics.
➢ self interest
➢ optimizing
➢ consistent
➢ accurate/full use of information, etc

➢ Standard economic analysis assumes ‘homo economicus’ (= ‘economic human’

or simply ‘econ’, meaning ‘rational man’)’.

➢ what if consumers do not always follow these “rational” models of economic

behavior?
 Example I
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➢ Experiment:
You have declared you are going on a diet. For an afternoon snack, which
one would you go for?

or

Finding:
• If to decide now for tomorrow’s snack: 74% selected Fruits
• If to decide now for today’s snack: only 15% selected Fruits

Implication: decision ≠ behavior.

(You don’t always behave as you decide)
 Example II
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With a practice account there are no consequences to trading decisions. With real
money at stake the emotions of fear, greed, loss aversion, and regrets of missed
opportunity come to the surface.

Implication: Demo accounts don’t always represent reality.

 Example II
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After all, we are not always rational.

─ You may not see or sense obvious things. (You may not even know you
can’t see or sense.)
─ We do make wrong or bad choices (like smoking) – due to lack of will or
various behavioral biases.
─ Many business decisions are not free from such an illusion, either.

If wrong choice/behaviors are made in a random fashion, then it does

not constitute a science. However, behavioral scientists/economists
observed that such wrong/bad decisions and behaviors are often
systematic – i.e. repeatable and predictable.

This is what the new field of behavioral economics is about.

 Subjective Probability Weighting
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➢ Let us compare A with B (Choice 1), and C with D (Choice 2):

Option A Option B
Sure gain of $36 80% chance to win $45

Option C Option D
25 % chance to win $36 20% chance to win $45

➢ Results: 78% preferred A to B; 42% preferred C to D.

➢ Note that, winning chances were lowered to the same 1/4 from A to C and B to
D, respectively. Therefore,

▪ Based on the assumption of rationality,

─ If you preferred A to B, then you should prefer C to D. (And vice
versa.)

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➢ Under a risky/uncertain situation, we assign a subjective probability weighting to

objective probabilities – sometimes overweight and sometimes underweight.

➢ Particularly, we prefer certainty to uncertainty: “Certainty Effect”

─ A reduction in winning chance is always a displeasure. But, we feel, a reduction

results in larger psychological effect when it is a reduction from certainty than
from uncertainty.
 Reference Point Matters
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➢ Reference point
A basis or standard for evaluation, location, assessment, or comparison.

➢ The reference point can strongly affect that decision.

➢ Examples
➢ Just recall your spending during Black Friday:
‘Originally $90 but now 30%-Off’ vs ‘$58’.
➢ Housing cost affects one’s migration decision. Rent for a two-bedroom
apartment:
➢ $4,500 in San Francisco, $2,300 in Pittsburgh, $1,500 in Buffalo
 Status Quo Bias
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➢ Status quo bias/Endowment Effect is an emotional bias; a preference for

the current state of affairs.

➢ You are a house owner. You purchased your house at 2 million. Would you
sell it at 1.5 million?
▪ Experiment on the price of mugs
(Kahneman, Knetsch, and Thaler, ‘Anomalies - The Endowment Effect, Loss
Aversion, and Status Quo Bias,’ Journal of Economic Perspectives)

Result:
The randomly assigned owners of a mug required significantly
more money to part with their possession ($7.12) than randomly
assigned buyers were willing to pay to acquire it ($2.87).
 "Opt Out" Policies Increase Organ Donation
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➢ In countries such as Austria, laws make organ donation the default option at
the time of death, and so people must explicitly “opt out” of organ
donation. In these so-called opt-out countries, more than 90% of people
donate their organs.

➢ Yet in countries such as U.S. and Germany, people must explicitly “opt in” if
they want to donate their organs when they die. In these opt-in countries,
fewer than 15% of people donate their organs at death.

➢ This policy targets people’s perceptions of what is the normal and usual
thing to do—the status quo. People tend to conform to the status quo. In an
opt-out country, the status quo is to donate organs upon death.
 Loss Aversion
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➢ Imagine two people in the same

general financial situation. One
loses $50; the second finds $50.
The first person should lose about
as much satisfaction as the
second person gains?

➢ The pain from a loss and the

pleasure from the same size of
gain is not symmetric.

➢ Businesses inspire purchases by

reminding customers that they
could lose out of they don’t “act
now!”.
 Framing Effects
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➢ Framing Effects
A tendency to rely on the context in which a choice is described when
making a decision.

➢ Example
Are you more likely to buy a skin cream whose package claims that it will
“slow the aging process” or one that is described as “making you feel young
again”. These products might be essentially identical except for their
packaging.
 Anchoring Effects
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➢ Our first perception of something lingers in our minds and this continues to
influence later decisions. People ‘anchor’ on one trait or piece of information
when making decisions.

➢ Examples
➢ Rather than asking for a gift of any amount, the charity asks you to
choose: $20, $50, $100, $250, or “other.”
➢ The price of a painting sold at an art auction and the experts' pre-sale
valuations are anchored on the price at which the painting previously
sold at auction.
 Nudging
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➢ Behavioral findings of human nature

and psychology can manipulate
people’s decisions. It can also help
people make choices more
beneficial to the society: Nudging.
 Example of Nudging
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➢ How to make people reduce energy use?

➢ Simple ways
Government or environmentalists do campaigns through automated text
messages, emails, letters, etc.
(How effective would it be?)

➢ Nudging
SP Group (Singapore Power) slightly change utility bills:
 Example of Nudging
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➢ How to make people save money for retirement?

➢ “Save More Tomorrow” Plan (Pension Protection Act of 2006)

➢ Instead of asking employees to commit to saving more money
immediately, this plan allows employees to commit to saving a higher
percentage in the future.

➢ Over time, as income increases, they gradually save more for

retirement without decrease in their current standard of living.

➢ By framing as a commitment to future behavior rather than an

immediate sacrifice, employees are more willing to participate.