UNCERTAINTY AND CONSUMER

BEHAVIOUR

1.Describing risk
2.Preferences towards risk
3.Reducing risk
4.The demand for risky assets
Probability - Likelihood that a given outcome will
occur.
Expected value - Probability-weighted average of the
payoffs associated with all possible outcomes.
Payoff - Value associated with a possible outcome.
 PROBABILITY
Let us take an example of an oil exploration
company. The present share of the company is $30.
If the company succeeds in its new venture than the
share will rise to $40 or else it will reduce to $20.
The probability of success and failure of oil
exploration are ¼ and ¾ respectively, which is
derived from the previous experience.
The expected value measures the central tendency - the payoff or
value that we would expect on average.
Expected value =Pr(success)($40/share)+Pr(failure) ($20/share)
= (1/4)($40/share) + (3/4)($20/share) =
$25/share
With two possible outcomes, the expected value is
E(X) = Pr1X1 + Pr2X2
When there are ‘n’ possible outcomes, the expected value becomes
E(X) = Pr1X1 + Pr2X2 + . . . + PrnXn
• Variability - Extent to which possible outcomes of an
uncertain event differ.
• Deviation – Difference between the expected payoff
and actual payoff.
• Standard deviation- Square root of the weighted
average of the squares of the deviations of the payoffs
associated with each outcome from their expected
values.
VARIABLITY
Particulars OUTCOME 1 OUTCOME 2 EXPECTED
INCOME
PROBABILITY INCOME ($) PROBABILITY INCOME ($)

Job 1: Commission 0.5 2000 0.5 1000 1500

Job 2: Fixed Salary 0.99 1510 0.01 510 1500
For Job 1 Expected income is 0.5x$2000 + 0.5 x $1000 = $1500
For Job 2 Expected income is 0.99x$1510 + 0.01x $510 = $1500

DEVIATIONS FROM EXPECTED INCOME

Particulars Outcome 1 Deviation Outcome 2 Deviation
Job 1 2000 500 1000 -500
Job 2 1510 10 510 -990
Deviations do not provide a measure of variability. Values may be positive or negative. To get rid
of this, we square the variations and then measure the variability by calculating the standard
deviation.
Deviation Squared Deviatio Squared Weighted Standard deviation
deviation n deviation average deviation
squared
500 250000 - 500 250000 250000 500
10 100 - 990 980100 9900 99.50

Weighted average deviation squared for job 1 is given by = 0.5 x $250000 + 0.5 x $250000 =
$250000
Standard deviation = 500
Weighted average deviation squared for job 2 is given by = 0.99 x $100 + 0.01 x $980100 = $9900
Standard deviation = 99.50
The second job is less risky than the first job.
 Decision Making
Suppose we add $100 to each of the payoffs in the first job, so that the expected
payoff increases from $1500 to $1600.
The two jobs can now be described as follows:
Job 1: Expected Income = $1600, Standard Deviation = $500
Job 2: Expected Income = $1500, Standard Deviation = $99.50
Job 1 offers a higher expected income but is much riskier than Job 2.
Which job is preferred depends on the individual. While an aggressive
entrepreneur who doesn’t mind taking risks might choose Job 1, with the higher
expected income and higher standard deviation. Whereas a more conservative
person might choose the second job.
Expected utility - Sum of the utilities associated with all
possible outcomes, weighted by the probability that each
outcome will occur.
Risk averse - Condition of preferring a certain income to a
risky income with the same expected value.
Risk loving- Condition of preferring a risky income to a
certain income with the same expected value.
Risk neutral- Condition of being different between a
certain income and an uncertain income with the same
expected value.
Risk premium - Maximum amount of money that a risk-
averse person will pay to avoid taking a risk.
 PREFERENCES TOWARDS RISK

In the example a person has a certain income of $20,000 or a

job with income $30,000 with probability 0.5 and an income of $10,000
with probability 0.5. The expected utility of the uncertain income is 14
point F (Average of point A and point E). The expected utility for income
earned without risk is 16, which is higher that the uncertain income.
For risk averse person losses are more important than gains.
Increase in income from $20,000 to $30,000 generates an gain of two
utility and a decrease in income from $20,000 to $10,000 generates a loss
of six units.
 RISK NEUTRAL

Person with risk neutral is indifferent

between a certain income and an
uncertain income with the same expected
value. The utility associated with a job
generating an income of either $10,000 or
$30,000 with equal probability is 12, as is
the utility of receiving a certain income
of $20,000. The marginal utility of
income is constant for a risk neutral
person.
 RISK LOVING
Person loving risk 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. The expected utility of
an uncertain income, which is either $10,000 with
probability 0.5 or $30,000 with probability 0.5, is
higher than the utility associated with a certain
income of $20,000. Numerically it is:

E(u) = 0.5u($10,000)+0.5u($30,000) = 0.5 (3) + 0.5

(18)
= 10.5 > u($20,000) i.e., 8
 REDUCING RISK
1. DIVERSIFICATION - Practice of reducing risk by allocating
resources to a variety of activities whose outcomes are not closely
related. Eg. Selling AC and Heaters
• Negatively correlated variables - Variables having a tendency
to move in opposite directions. Sales of one is strong and the
other is weak at a time.
• Mutual funds - Organization that pools funds of individual
investors to buy a large number of different stocks or other
financial assets.
• Positively correlated variables - Variables having a tendency
to move in the same direction. Stock prices tend to move in the
same direction in response to changes in economic conditions.
2. INSURANCE
The risk averse people are willing to pay to avoid risk. If the
cost of insurance is equal to the expected loss, risk averse
people will buy enough insurance to recover fully from any
financial losses they might suffer.
LAW OF LARGE NUMBERS:
Insurance companies by selling large number of policies, they
face relatively little risk. This tells us that although single
events may be random and largely unpredictable, the average
outcome of may similar events can be predicted.
3. THE VALUE OF INFORMATION
The difference between the expected value of a choice
when there is complete information and the expected value when
information is incomplete.
The value of information is computed as
Expected value with complete information:
$ 8500
Less: Expected value with uncertainty
–$ 6750
Equals:Value of complete information
$ 1750
Thus it is worth paying up to $1750 to obtain an accurate
prediction of sales.
 THE TRADE OFF BETWEEN RISK AND RETURN
An individual wants to invest the savings in two assets – short term
government bonds which are risk free and a group of stocks. The
individual should decide how much to invest in each asset. The individual
can invest in bonds or stocks or a combination of both.

At the time of investment decision, we know the set of possible outcomes

and the likelihood of each, but we do not know what particular outcome
will occur. The risky asset will have a higher expected return than the risk
free asset. Otherwise, risk averse investors would buy only short term
government bonds and no stocks will be sold.