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Session 6 - 7

This document discusses decision making under uncertainty. It explains that individuals face uncertainty about states of nature and their actions and the resulting payoffs. Expected utility theory is introduced as a way to model how individuals make choices under risk by using probability and utility functions. The key concepts of risk aversion, risk neutrality, and risk loving attitudes are defined based on the shape of the utility function. Certainty equivalents and risk premiums are introduced as ways to measure risk aversion. Portfolio choice examples are provided to illustrate how risk averse individuals diversify and make optimal choices between risky and riskless assets.

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70 views16 pages

Session 6 - 7

This document discusses decision making under uncertainty. It explains that individuals face uncertainty about states of nature and their actions and the resulting payoffs. Expected utility theory is introduced as a way to model how individuals make choices under risk by using probability and utility functions. The key concepts of risk aversion, risk neutrality, and risk loving attitudes are defined based on the shape of the utility function. Certainty equivalents and risk premiums are introduced as ways to measure risk aversion. Portfolio choice examples are provided to illustrate how risk averse individuals diversify and make optimal choices between risky and riskless assets.

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V SURENDAR NAIK
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We take content rights seriously. If you suspect this is your content, claim it here.
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Consumer Choice Under Risk

EC101 – Lecture 7
• Uncertainty
– All face the same (rain / sunshine; economic slowdown)
– Information assymetries exist (CEO vs operator)
• Reaction
– Passive
– Active
• State of nature
– (rain, sun, cloudy)
– (high infl, low infl, high deficit…)
• Acts
– Carry umbrella, don’t
– Postpone buying decision, buy, don’t invest….)
• Payoffs = outcome (get wet, stay dry)
• Uncertainty
– What about
– What form?
• Know frequency distribution
• Have some idea of frequency distribution
• Know the extent of variation, but no ideas on freq.
• No clue
– What to do? – try to formulate as:
• States of nature : (1,2,..,s,..,S)
• Actions: (1,2,..,x,.., X)
• Consequence function c(x,s) = payoffs
Expected Utility
• Use probability theory to reach decisions in
uncertain situations
• Expected utility rule:
U(x) = ∑ps‫[ע‬c(x,s)]= E ‫(ע‬s)
– vNM utility fxn: ‫√=ע‬w; initial wealth = 36;
– Gamble: win 13 with prob 2/3 and lose 11 with
prob 1/3
– Will she accept?
Decision-making under Uncertainty
Example: Choice between two “random prospects”:

• Two 1-year projects X and Y with uncertain returns


– they require the same up-front investment of $1 million
– X will give p.v. returns of $2 mil. or $3 mil. with equal probability
– Y will give p.v. returns of $2.32 mil. or $2.6 mil. with equal probability
• In effect, the choice is between two “random variables”:
X = {1, 2; 0.5, 0.5}, Y = {1.32, 1.6; 0.5, 0.5}
• X has higher mean (expected value) and also higher variance than Y
• Your choice will depend upon your “attitude towards risk”
Issue: How do we model an individual's preference-rankings over
“random prospects” of the form: Z = {z1, z2, …, zN; μ1, μ2, …, μN)

where [z1, z2, …, zN] are alternative monetary returns and [μ1, μ2, …, μN]
are the associated probabilities?
The Expected Utility Hypothesis
Daniel Bernoulli; John von Neumann & Oskar Morgenstern

• Let the preferences of a person over “sure money” be represented


by a Bernoulli utility function u(z) [z = alternative ‘sure’ money
amounts]
– plausible assumption that ‘more money is preferred to less’ implies that
u(z) is strictly increasing in z
• Then expected utility of a prospect Z for that person is defined to be:
EU(Z) = μ1u(z1) + μ2u(z2) + …+ μNu(zN)
• The expected utility hypothesis states that every person has his
personal Bernoulli utility function u(.), and prefers a random
prospect X to another random prospect Y if and only if EU(X) > EU(Y)
Expected Utility Theorem:
• If a person’s preferences over “random prospects” satisfy properties
of ‘completeness’, ‘transitivity’, ‘monotonicity’, and the
‘independence property’, then the expected utility hypothesis is valid
i.e., we can construct an expected utility
• Independence property: If prospect X is preferred to prospect Y, then
for any other prospect Z and any probability p, the compound
prospect {X , Z; p, 1–p} is preferred to the compound prospect {Y , Z;
p, 1–p}
Applying the theory: back to the ‘project
choice’ example
• Four persons A, B, C, D with different Bernoulli utility
functions:
uA(z) = z2; uB(z) = z; uC(z) = (z)1/2; uD(z) = (z)1/4
– A’s u function is convex: increasing ‘marginal utility of money’
– B’s u function is linear: constant ‘marginal utility of money’
– C’s u function is concave: decreasing ‘marginal utility of money’
– D’s u function is more concave than C’s
• A and B prefer X to Y, C is indifferent between X and Y, and D
prefers Y to X
• For any person I with Bernoulli utility function uI(.), any
‘increasing linear transformation’: vI(z) = a + buI(z) with b > 0
also represents his utility and satisfies the expected utility
property
– but an increasing non-linear transformation [e.g. vI(z) = log.uI(z)]
does not represent his utility
A: Risk Loving : U(E(z)) <E(U(z))
U(z)
B: Risk Neutral

B
C: Risk Averse
URA U(E(z)) >E(U(z))

URN (A, B; 0.5, 0.5)

URL

A
z zB z
Attitudes toward Risk
• A person is risk averse if it is always true that she prefers getting
the ‘mean’ of a random prospect for sure rather than getting the
prospect ⇔ A person is risk averse if and only if her u(.) is strictly
concave ⇔ U(E(z)) >E(U(z))
• A person is risk loving if it is always true that she prefers getting a
random prospect rather than getting its ‘mean’ ⇔ A person is risk
loving if and only if her u(.) is strictly convex ⇔ U(E(z)) <E(U(z))
• A person is risk neutral if it is always true that she is indifferent
between a getting a random prospect and getting the ‘mean’ for
sure ⇔ A person is risk neutral if and only if her u(.) is linear ⇔ [a
linear u(.) can be represented by identity function u(z)=z for all z]

• Most individuals are risk averse


– individuals differ in their aversion to risk (a ‘more risk averse’ person
has a ‘more concave u function’ than a less risk averse person)
– in general, the richer one gets the less risk averse she is (the extent of
concavity of u function decreases as wealth increases)
Measuring Risk Aversion: ‘certainty
equivalent’/ ‘risk premium’
• For a risk averse u, the certainty
equivalent C(Z) is the sure amount
associated with prospect Z such that:
u(C(Z)) = EU(Z)
and risk premium ρ(Z) associated with Z is:
ρ(Z) = EZ – C(Z)
• Thus, risk premium of a prospect Z for a
person is the max amount of money that
she would pay to receive the ‘mean’ of Z
rather than Z

• Comparing risk premia across individuals


for a particular random prospect is one
way to evaluate their relative aversion to
risk
• Inverting this logic, starting from a ‘safe
asset’, a risk averse person needs a ‘risk
compensation’ to accept a ‘risky asset’
Nitin’s Utility function
Nitin’s level of utility Utility Curve
increases from 10 to 16 to
18 as his income increases
from 10K to 20K to 30K=>
marginal utility falls from
10 to 6 to 2

marginal utility diminishes


as income increases.

Say Nitin’s income is 15K –


his utility is 13.5

1. Will he take up a job with


the following prospect,
Z={30,000, 10,000; 0.5,0.5}, 30

if his current income is a


certain 20,000?
Certainty Equivalent and Risk Premium
Z={30,000, 10,000; 0.5,0.5}
Expected Utility
Nitin is risk averse because
he would prefer a certain Utility Curve
income of $20,000 (with a
utility of 16) to a gamble
with a .5 probability of
$10,000 and a .5
probability of $30,000 (and
expected utility of 14).

A utility of 14 is equivalent
to a certain income of
16000. Hence 16000 is
the certainty equivalent
of his prospect of
(10000,30000; 0.5,0.5) and
Rs 4000 is his risk
premium.
Risk Premium = Maximum amount of money that a risk-averse person will pay to
avoid taking a risk
Certainty Equivalent and Risk Premium
Certainty equivalent of a risky choice Risk Averse Individual
is the amount of payoff, which if
provided with certainty, would leave
the individual equally well off
Risk Premium = Amount an
individual would give up to leave her
indifferent between the risky choice
and the certain one = expected
payoff – certainty equivalent
For choice Z, U (16000)=14 = U(Z)
 16000 = certainty equivalent
 20000-16000 = 4000 = risk
premium
If Y={0,40000; .5,.5},
E(Y) = 20000
EU(Y) = .5*0+.5*20 = 10
 10,000 = certainty equivalent
 20K-10K = 10,000 = risk premium

Greater the variability, lower the certainty equivalent and greater the risk premium
Same set of choices, different utility functions
Expected Utility
• b- risk loving
She would prefer
the same gamble Utility Curve
(with expected
utility of 10.5) to
the certain
10.5
income (with a
utility of 8).
• c – risk neutral
She is indifferent
between certain
and uncertain
events with the
same expected
income
Robust Behaviour under Risk Aversion
• ‘actuarially fair’ insurance
Insurance premium = promised benefit * probability of
the loss occurring.
Most insurance not actuarially fair – why?
A risk averse individual will always pay a “positive
premium” to insure against risk
• Portfolio Diversification
Hedging as a special case
If there are N risky securities that are independently and
identically distributed, a risk-averse person will divide
her total investment portfolio equally among the N
securities
• Investing in getting more information
A Portfolio Choice Example
• You have Rs. 1 million to invest in two financial securities for a year
Asset X is a bond with a certain interest of 10% p.a.
Asset Y is a stock that will go up by 21% over the year or stay
unchanged with equal probability [expected return = 10.5%]
• If you invest y (fraction of 1 million) in Y and rest in X, you get a
random prospect:
{1.21y + 1.10(1-y), y + 1.10(1-y); 0.5, 0.5}
• So your expected utility: 0.5u(1.21y + 1.10(1-y)) + 0.5u(y + 1.10(1-
y))
• Your optimal choice is that y* that maximizes your expected utility
– If u(z) = log z, then y* = 0.5 million [50-50 split]
• If I did not know your u function, I would still be able to predict:
(i) If X is a ‘safe asset’ with return rX% p.a., and Y is ‘risky asset’
with ‘expected return’ rY% p.a., then you will hold some Y iff rY > rX
(ii) If X and Y are i.i.d. risky assets with ‘common expected return’
r% p.a., then you will hold equal amounts of X and Y

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