CHAPTER TWO

CHOICE UNDER UNCERTAINITY

Main reference
 R.S. Pindyck and D.L.Rubinifeld, Microeconomics. Third edition, 1996..
CHAPTER FIVE, PAGE 159__ 185
Traditional demand theory, as examined until now, implicitly assumed a risk less world. It
assumed that consumers face complete certainty as to the results of the choices they make.
Clearly, this is not the case in most instances. In contrary to our assumptions of price income and
other variables to be known with certainty, many of the choices that people make involve
considerable uncertainty.
Although risk and uncertainty are usually used interchangeably, some people distinguish
between the two.
(I) Uncertainty: refer to a situation when there is more than one possible outcome to a
decision and where the probability of each specific outcome is not known. This may be
due to insufficient past information or instability in the structure of the variables.
Uncertainty occurs if each action has as its consequence a set of possible specific
outcomes, the probabilities of which are unknown.
(II) Risk: refers to a situation where there is more than one possible outcome to a decision
and the probability of each specific outcome is known or can be estimated. Risk
occurs if each action leads to one of a set of possible specific outcomes, each outcome
occurring with a known probability.
(III) Certainty: refers to a situation where there is only one possible outcome to a decision
and this outcome is known precisely. For example, investing on treasury bills leads to
only one outcome (i.e. the amount of the yield), and this is known with certainty.
Certainty occurs if each action is known to lead invariably (with no error) to a specific
outcome.
We need two measures to describe and compare risk choices. These measures are:
(I) Expected value: is the weighted average of all possible payoffs/outcomes that can result
from a decision under the various state of nature, with the probability of those payoffs

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 used as weights. It measures the value that we would expect on average. If we multiply
each possible outcome or payoff by its probability of occurrence and add these products,
we get the expected value. If, for instance, there are two possible outcomes having
payoffs X1 and X2 and if the probabilities of each outcome are given by P1 and P2, then
the expected value is:
E(X) = P1X1 + P2X2
When there are n possible outcomes, the expected value becomes;
E(X) = P1X1 + P2X2+……………… PnXn
The expected value measures the central tendency, that is, the average payoff.
Example: If the probability that an oil exploration project is successful is ¼ and the probability
that it is unsuccessful is ¾ and if success yields a payoff of 40 birr per share while failure a
payoff of 20 birr per share, the expected value is:
EV = p (success) (40 birr/share) + p (failure) (20birr/share)
= ¼ (40) + ¾ (20)
= 25 birr/share
(II) Variability: is the extent to which possible outcomes of an uncertain event may differ.
We measure variability by recognizing that large differences between actual and
expected value imply greater risk. Standard deviation is the often used measure of
variability. Standard deviation measures the dispersion of possible (actual) outcomes
from the expected value. The smaller the value of SD, the tighter or less dispersed the
distribution is and the lower the risk attached to it and vice versa.

Standard deviation (SD) -  =  P1(X1-E(X)) 2 + P2(X2-E(X)) 2

 If two alternatives to choose from have the same expected value, the one with the
lower/smaller standard deviation is less risky and hence is preferred. If, however, one
alternative offers a higher expected value but is much riskier than the other one and
vice versa, the preference depends on the individual – whether he/she is a risk averse,
risk neutral or a risk loving person.
DIFFERENT PREFERNCE (PERSON’S ATITTUDES) TOWARDS RISK
1. A RISK AVERSE PERSON:- is a person who prefers a certain income to a risky income
with the same expected value. For a risk averse person losses are more important (in terms of

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 the change in utility) than gains. Losses hurt him/her more seriously than gains benefit
him/her. Thus, the MU of income diminishes as income rises.
Assume that the person can either have a certain income of birr 20, or an alternative decision
yielding an income of 30 birr with probability of 0.5 and an income of 10 birr with probability
0.5. The expected income of this alternative is, EV = 0.5(30) + 0.5(10) = 20 birr. This is the same
as the income earned without risk. He/she prefers to consume the risk less 20 birr to trying the
alternative in which he/she could have consumed 30 birr if successful or 10 birr if unsuccessful.
Utility at B > utility at C (16>14). The risk averse person achieves the expected utility of 14 at a
lower but risk less income of 16 birr. Thus, he/she is willing to pay birr 4 (20-16) to avoid taking
risk. The maximum amount of money (4 in our case) that a risk averse person will pay to avoid
taking a risk is called a risk premium.
Utility of this risk averse person is 14 = 0.5(10) + 0.5(18).
Risk aversion corresponds to a concave utility function representing DMUy.

Consider the following graph for the above explanation.

Utility

18 E
16 B
14 D C

A
10

O 10 16 20 30 income

- Mu at D is < Mu at A
- To get a sure income of birr 16, the risk averse agent is willing to forgo birr 4.
A risk averse individual never accepts a fair gambling.

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 Risk aversion is thought to be the most common behavior that is why the neo-classical
use a concave utility function.

Example:
Suppose you are offered a 50-50 chance of winning Birr 5000 and loosing the same amount, risk
averse individuals will not take this.
2. A RISK NEUTRAL PERSON: - is a person indifferent between a certain income and an
uncertain income with the same expected value. For this person, the MU of income is
constant.
 If prospects/lotteries are valued at their expected values there is risk neutrality.

 A decision maker is risk neutral if he is always indifferent between two lotteries with the
same mathematical expectation.

 She only cares about the mean disregarding the variance, that is, risk.

 It corresponds to a linear utility curve representing a constant MU.

Consider the above example again.
E (U) = 0.5U (10) + 0.5U (30)
= 0.5(6) + 0.5(18)
= 12
=> E (U) = U (20) = 12
Utility
18 E

12 C
6 A

income
0 10 20 30

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 A risk neutral individual would:

(a) Be indifferent to gambles which are just fair

(b) Accept gambles that are better than fair
(c) Rejects gambles that are worse than fair
3. A RISK LOVING PERSON: - is a person who prefers a risky income to a certain income
with the same expected value. This person 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.
E (U) = 0.5U (10) +0.5U (30)
= 0.5(3) + 0.5(18)
= 10.5
 E(U) > U(20)
 10.5 > 8
 The expected utility of the uncertain income is greater than the utility of a certain income
for a risk loving person and thus their utility of income curve is upward bending
U 18
E

10.5
8
C
3
O 10 20 30 Income

- Risk loving people are few, at least with respect to major purchases or large amounts of
income or wealth.
- Risk loving people prefer alternatives with high expected value and high standard
deviation (risk) to a lower paying but less risky alternative (unlike the risk averse people).
NB: Expected utility E (U) is the sum of the utilities associated with all possible outcomes,
weighted by the probability that each outcome will occur.

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 In short,
 If prospects are valued at more than their expected values, there is risk attraction or risk
loving.

 A risk loving individual would accept any fair gamble and up to a point even gambles that
are worse than fair.

 Risk loving corresponds to a convex utility curve representing Increasing MU.

RISK AVERSION AND INDIFFERENCE CURVES
We also describe the extent of a person’s risk aversion in terms of indifference curves that relate
the expected income to the variability of income, the latter being measured by the standard
deviation. An IC shows the combination of expected income and standard deviation of
income that give the individual the same amount of utility. ICs are upward sloping. This is
because risk is undesirable so that the greater the amount of risk, the greater the amount of
income needed to make the individual equally well-off. An increase in the standard deviation (a
higher variability of income) must be compensated by a higher expected income so as to a very
leave a risk averse person on the same level of utility. In the case of a slightly risk averse person,
a large increase in the standard deviation of income requires only a small increase in expected
income.
E(I) U3 E(I)
U2
U3
U2
U1
U1

O O
Standard deviation of income () Standard deviation of income ()
(A) A high risk averse person (B) A slightly risk averse person

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REDUCING RISK
In the face of a broad variety of risky situations, people are generally risk averse. Consumers and
managers commonly reduce risk in various ways. The major ones are diversification, insurance
and obtaining more information.

1. Diversification: - reducing risk by allocating resources to a variety of activities whose

outcomes are not closely related –“Don’t put all your eggs in one basket.”
2. Insurance: - If the cost of insurance is equal to the expected loss, risk averse people will
buy enough insurance to recover fully from any losses they might suffer. For a risk averse
consumer, the guarantee of the same income regardless of the outcome generates more utility
than would be the case if that person had a high income when there was no loss and a low
income when a loss occurred.
3. The value of information: - people often make decisions based on limited information. If
more information were available, one could make better predictions and reduce risk. Even
though forecasting is inevitably imperfect, it may be worth investing in a marketing study
that provides a reasonable forecast for the future.
Exercise 2
1. Consider a lottery with three possible outcomes: $100 will be received with probability 0.1,
$50 with probability 0.2, and $10 with probability 0.7.
a. What is the expected value of the lottery?
b. What is the standard deviation of the outcomes of the lottery?
c. What is the expected utility of the outcomes of the lottery if the utility
associated to $100 will be 20, $50 will be 10, and $10 will be 7?
2. Define the following terms in a complete way
b. Certainty
c. Uncertain
d. Risk
1. List the three major ways of reducing risk
2. List and discuss the two measures used to describe and compare risk choices (for H2 and
B1).

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3. What does mean to say that a person is risk averse? Why are some people likely to risk
averse, while others are risk lovers? Explain your answer; your personal opinions are very
important (for H2 and B1).
4. Suppose an investor is concerned about a business choice in which there are three prospects
whose probability and returns are given below(for H2 and B1):
Probabilit Returns (in
y $1000)
0.2 100
0.4 50
0.4 -25

i. What is the expected value?

ii. What is the standard deviation of the outcomes?
iii. What is the expected utility of the outcomes of the lottery if the utility associated to $100
will be 30, $50 will be 20, and $-25 will be 5?

Discussion Points:
a. When is it worth paying to obtain more information to reduce uncertainty?
b. How does the diversification of an investors’ portfolio avoid a risk?
c. Suppose you are choosing between two part-time sales jobs that have the same
expected income ($1500). The first job is based entirely on commission- the income
earned depends on how much you sell. The second job is salaried. There are two
equally likely incomes, under the first job $2000 for a good job sales effort and
$1000 for one that is only modestly successful. The second job pays $1510 most
time, but you would earn %510 in severance pay if the company goes out of
business. The below table summarize these possible outcomes, their payoffs, and
their probabilities.
Outcome 1 Outcome 2
probabilit Income probabilit Income
y ($) y ($)
Job 1: Commission .5 2000 .5 1000
Job 2: Fixed salary .99 1510 .01 510

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 a. Which job would you take? Why? Justify your answer using the concept of
variability.
b. Which job would you take if you are risk
i. Averse
ii. Lover
iii. Neutral

 NOTE: The lecture note, exercise 2, and discussion points are entirely based on the book
of R.S. Pindyck and D.L.Rubinifeld. Microeconomics. Third edition, 1996. CHAPTER
FIVE, PAGE 159__ 185 (Request: Refer the book for more pleasure-seeking).

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