A Presentation on Choice Under

Uncertainty
Consumption in different states of nature can be viewed as consumption goods,
and all the analysis of previous discussion can be applied to choice under
uncertainty.
 Concept Of Lottery

 What is Lottery?
 Lottery means simply a probability. Suppose a consumer has ₹100 and
purchases a lottery ticket of number 20 by ₹5. If the ticket is a winner then
the consumer will get ₹200 and the total amount of the consumer will be (100
- 5) + 200 = ₹295. And if the ticket is not winner then the consumer will lose
₹5, then total amount of the consumer will be ₹95. There are three types of
consumer-  1.Risk averse, 2.Risk lover and 3.Risk neutral.
 Utility Function

 Expected Utility Function: 

   Expected utility= Σuipi     ,  i=1,2,3,......,n
   Where u1,u2,…...,un are numbers and p1,p2,….....,pn are the corresponding
lotteries.
   What is Expected Utility? 
 Expected Utility Hypothesis

 The expected utility of an entity is derived from the expected utility

hypothesis. That under uncertainty the weighted average of all possible levels
of utility will best represent the utility at any given point in time.
 Expected utility theory is used as a tool for analyzing situations in which
individuals must make a decision without knowing the outcomes that may
result from the decision, i.e, decision making under uncertainty. These
individuals will choose the action that will result in the highest expected
utility, which is the sum of the products of probability and utility of over all
possible outcomes. The decision mode will also depend on the consumers risk
preference and the utility of other agents.
 Risk Aversion

Suppose that a consumer has ₹10 and is contemplating a gamble that gives a 50%
probability of winning ₹5 and 50% probability of losing ₹5. Then profit will be
₹15 and loss will be ₹5. The expected value of his wealth is ₹10, and the
expected utility is  [0.5u(₹15)+0.5u(₹5)]
Note that in the previous diagram the expected utility of wealth is less than the
utility of the expected wealth. That is
u(0.5*15+0.5*5)=u(10)>0.5u(15)+0.5u(5).
In this case we say that the consumer is risk averse since the consumer prefers to
have the expected value of his wealth rather than face the gamble.
Risk Aversion
 Risk Lover

Of course, it could happen that the preferences of the consumer curve such that
he prefers a random distribution of wealth to its expected value, in which case
we say that the consumer is a risk lover.
Difference Between Risk Averse
and Risk lover
 Risk Neutral

The intermediate case is that of a linear utility function. Here the consumer is risk
neutral:

The expected utility of wealth is the utility of its expected value. In this case the
consumer dosen't care about the riskness of his wealth at all, only about its
expected value 
Thank You