Scribd
Upload
58 views24 pages

Micro ch12

1) When choices involve uncertainty, expected utility theory says people maximize expected utility rather than expected value. 2) People are generally risk averse if they have concave or diminishing marginal utility functions. 3) Risk aversion means preferring a sure outcome over a gamble with higher expected value but risk of loss.

Uploaded by

Maham Khan
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
58 views24 pages

Micro ch12

1) When choices involve uncertainty, expected utility theory says people maximize expected utility rather than expected value. 2) People are generally risk averse if they have concave or diminishing marginal utility functions. 3) Risk aversion means preferring a sure outcome over a gamble with higher expected value but risk of loss.

Uploaded by

Maham Khan
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 24

1

Intermediate Microeconomics
W3211

Lecture 23: Uncertainty and


Information 1: Expected Utility
Theory
Columbia University, Spring 2016
Mark Dean: [email protected]
Introduction

2
3
The Story So Far….
• We have spent a lot of time modelling the choices made
by
• People
• Firms

• In doing so, we have always assumed that people knew for sure
what the outcome of those choices were
• If you buy a commodity bundle, you get those things for sure
• If a firm produces y output, they are 100% certain that they will be
able to sell them at price p
4
Today
• In many cases the outcome of our choices are uncertain
• For example
• You are deciding whether or not to buy shares in Apple
• You are deciding whether to gamble your student loan on black on
the roulette table
• You are deciding whether or not to buy beachfront property in
Miami

• The aim of this lecture is to think about how we model such


choices
• Chapter 12 Varian, Chapter 19 Feldman and Serrano
Choice under Uncertainty
What should I maximize?

5
6
What Should I Maximize?

 When we thought about how consumers behave, we had a


very specific model
 They should make choices to maximize their preference (or utility)

 How can we extend this model to choices over things which


are uncertain?
7
What Should I Maximize?

 Here is an example of a very boring fairground game


 You pay an amount x to play the game
 If you play, the fairground person flips a (fair) coin
 If it comes down heads you win $10
 If it comes down tails, you win $0

 So
 If you don’t play the game you get $0 for sure
 If you play the game, with 50% chance you get $10-x and with 50%
chance you get –x

 What is the most you would pay in order to play such a game?
 i.e. how big an x?
8
What Should I Maximize?

 $5?
 This is the expected (or mean) value of the game
Prob($10).10+Prob($0).0
9
What Should I Maximize?

 Okay, here is a new game


 The fairground person flips a coin
 If it comes down tails you get $2
 If it comes down heads, the coin gets flipped again
 If it comes down tails, you get $4
 If it comes down heads, the coin gets flipped again
 If it comes down tails you get $8
 If it come down heads, the coin gets flipped again
 Etc. etc

 How much would you pay to play the game?


10
What Should I Maximize?

 Well, what is the expected value?


Prob($2).2+Prob($4).4+Prob($8).8…

1 1 1 1
.2 .4 .8 . 16
2 4 8 16
1+1+1+1…. ∞!
 Would you pay a million dollars to play this game?
 Would you pay a billion?
11
What Should I Maximize?

 Here is another question


 Let’s say a pauper finds a magic lottery ticket, which pays
$1,000,000 with 50% chance and $0 otherwise
 A wealthy toff offers them $475,000 for the lottery ticket
 Should they accept the offer?
 If they are maximizing expected value they should not!
 Is this sensible?
12
Expected Utility

 Most of economics assumes that what you maximize is not


expected value, but expected utility
 So the pauper should figure out the utility they get from $0, the
utility they get from $475,000 and the utility they get from
$1,000,000

 Then compare 0 1,000,000 to 475,000

 Compare the expected utility of the gamble to the expected


utility of the sure thing
13
Expected Utility and Risk Aversion

 Question: when would they prefer the sure thing to the gamble,
even though the gamble has a higher expected value?
 Answer: when their utility function is concave
14
Expected Utility and Risk Aversion

Utility

Money
15
Expected Utility and Risk Aversion

Utility

u(1,000,000)

1 million Money
16
Expected Utility and Risk Aversion

Utility

u(1,000,000)

1/2u(1,000,000)
+1/2u(0)

1 million Money
17
Expected Utility and Risk Aversion

Utility

u(1,000,000)

1/2u(1,000,000)
+1/2u(0)

475,000 1 million Money

• If pauper prefers to get the money for sure, u(475,000)


must be above 1/2u(1,000,000)+1/2u(0)
18
Expected Utility and Risk Aversion

Utility

u(1,000,000)

u(475,000)

1/2u(1,000,000)
+1/2u(0)

475,000 1 million Money


19
Expected Utility and Risk Aversion

Utility

u(1,000,000)

u(475,000)

1/2u(1,000,000)
+1/2u(0)

475,000 1 million Money

• Requires utility function to be concave


20
Expected Utility and Risk Aversion

 Intuition is as follows
 The additional utility from getting $475,000 relative to $0 is huge
 The additional utility from getting $1,000,000 relative to $475,000
is much smaller
 So the additional utility gained from winning the lottery is
relatively small
 Not worth the additional risk
21
Expected Utility and Risk Aversion

 This is the idea of diminishing marginal utility of wealth


 The utility from an additional dollar is lower when you are rich than
when you are poor

 Diminishing marginal utility is exactly the same as saying the


utility function is concave
 Slope of the utility function is decreasing
22
Expected Utility and Risk Aversion

 Definition: we say someone is risk averse if, for any lottery, they
prefer to receive the expected value of that lottery for sure
than play the lottery
 E.g., for a lottery which pays 1/3 $30, 1/3 $15, 1/3 $0,
 They would prefer $15 for sure

 An expected utility maximizer is risk averse if and only if they


have a concave utility function
 i.e. decreasing marginal utility of money
Summary

23
24
Summary

 We have introduced the idea of expected utility as a way


of modelling the way people make choices over risky
options

You might also like