Chapter b Choice under Uncertainty After learning this chapter you will understand : Risk & State of Nature. Probability Y¥ — Objective Probability, ¥ — Subjective Probability. Risk Preferences. Certainty Equivalents and Risk Premiums. Arrow-Pratt Coefficient of Risk Aversion. Weighted Utility. Prospect Theory. For Full Course Video Lectures of ALL Subjects of Eco (Hons), B Com (H), BBE, MA Economics, UGC Net Economies, Indian Economic Service (IES) Register yourself at www.primeacademy.in Dheeraj Suri Classes Prime Academy 9899192027Prime Academy, www.primeacademy.in Basic Concepts 1 Risk : Risk exists whenever the consequences of a decision are uncertain. wv State of Nature : The different possible outcomes of a risky decision are state of nature. These are outside the control of the decision maker. w Probability : Probability measures the likelihood of occurrence of a state of nature. The probabilities of all states of nature always add up to 1 (i) Objective Probability : The probability of a state of nature measured by determining the frequency with which it has occurred in the past, under comparable conditions. (ii) Subjective Probability : The probability of a state of nature which is a measure of the likelihood that an event will occur based on subjective judgment. 4. Uncertain Payoff : Risky choices often have financial consequences, also known as payoffs. Payoffs can be either positive, known as gain, or negative known as losses. To determine a choice we need to know the probability distribution of the payoffs. The probability distribution of a set of payoffs tells us the likelihood that each possible payoff will occur. 5. Mathematical Expectation : Let X be a random variable which takes xi, x2, X3..... Xq mutually exclusive values with respective probabilities p., p». ps. Then the expected value or mean of X denoted by E(X) or 1 is given as under : E(X) Spi. xi + po. kat ps. Xt oo. + Pas Xe 6. Expected Payoff : The expected payoff of a risky financial choice is a weighted average of all the possible payoffs, using the probability of each payoff as its weight. Expected payoff or Expected Value (EV) = ¥ pix; For example, You are made the following proposal : You have the right to roll a die once. You then roll the die and are paid the number of rupees shown on the die. The expected payoff of the uncertain die throw is : Expected Payoff = 1x8 42x143¥b 44x by5xte6xteas 6 6 6 6 6 6 7. Variability : The variability of payoffs is an indication of risk. If the value of variability is small then the actual value is approximately same as the expected value whereas for large value of variability the actual value is quite different from the expected value. The variance or standard deviation of a risky financial payoff is a measure of risk. Variance : The average squared deviation of a lottery from its EV, weighting each squared deviation by the associated probability of that outcome. Variance = ¥ p)(x; — EV)? Standard deviation (SD) is the square root of the variance, or SD = Var. Micro Economics 6. By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in 8. Expected utility (EU) : The average utility of a lottery, weighting each utility with the associated probability of that outcome Expected Utility (EU) = ¥ ppU; The definition of EU is similar to that of EV, as both approaches weight payoffs according to their probability, assigning a larger weight to more likely outcomes. However, EU plugs each payoff into the individual’s utility function to better assess how important that payoff is for her, while EV considers only payoffs, without evaluating their utility for the individual. 9. Risk Preferences : Risk preference is ones tendency to choose a risky (such as an investment that has equal chance to yield a 20% or a 0% return) or less risky option (such an investment with a guaranteed return of 5%). Generally, economists and financial professionals apply the concept of risk preference to investors and economists, but you can also apply risk preference to any decision you make that involves risk. Several types of risk preference exist, and the associated risk involved generally depends on the decision maker and for whom the decision maker takes the risk. We can classify the individuals on the basis of risk preferences as under : (i) | Risk Averse, (ii) Risk Lover, and (ii) Risk Neutral 10. Risk Aversion : A person is risk averse if in comparing a riskless bundle to a risky bundle with the same level of expected consumption, he prefers the riskless bundle. This definition captures the idea that, by itself, variability is a bad thing. Intuitively, the utility of the EV or, more compactly, U(EV) in a risky bet represents the utility that the individual obtains if she received the EV with certainty, without having to face the risk of taking the bet and if U(EV) > EU then the person is risk averse. Risk-averse attitudes emerge when an individual's utility function is concave, for example the utility function U(J) = vI represents risk averse utility function. 11. Risk Loving : A person is risk loving if in comparing a riskless bundle to a risky bundle with the same level of expected consumption, he prefers the risky bundle. So, it means that a risk loving individual will voluntarily accept higher variability even if it isn’t associated with a higher level of expected consumption. Intuitively, this says that the individual is a “risk lover” because she prefers to play the lottery and face risk (obtaining EU) to receiving the EV of the lottery with certainty, where she obtains u(EV), i.c., U(EV) < EU. Risk-loving attitudes emerge when an individual’s utility function is convex, for example the utility function U(/) = P represents risk loving utility function. Micro Economics 63 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in 12. Risk Neutral : A person is risk neutral if he is indifferent between the bundles with same level of expected consumption irrespective of their level of risk. Risk neutrality arises when an individual’s utility function is linear, thus exhibiting the form U(/) = a + bI, where a and b are positive constants. 13. Risk premium (RP) : The amount of money that we need to subtract from the EV in order to make the decision maker indifferent between playing the lottery and accepting the EV from the lottery. That is, the RP solves U(EV— RP) = EU. For a risk averse individual the Risk premium is positive, whereas for a risk lover individual the risk premium is negative. Also, the risk premium is zero for risk averse individual. 14. Certainty equivalent (CE) : A useful concept is the certainty equivalent of a gamble. The amount of money that, if given to the individual with certainty, makes her indifferent between receiving such a certain amount and playing the lottery. The certainty equivalent is an amount of money that provides equal utility to the random payoff of the gamble. ‘That is, CE = EV — RP. 15. The Arrow-Pratt Coefficient of Absolute Risk Aversion : The Arrow-Pratt coefficient of absolute risk aversion (AP for short) uses the concavity of the utility function to measure risk aversion, Arrow-Pratt coefficient of absolute risk aversion (AP) This coefficient is given by AP=— > where the denominator, u’, represents the first-order derivative of the individual’s utility function u(/) with respect to income /, while the numerator, w”’, denotes the second-order derivative. Theory Questions ] QI. If the same person acts as a risk avoider (purchases fire insurance) and also acts as a risk seeker (gambles). Can one explain such seemingly contradictory behavior ? Q2. Why might it make sense for a risk averse person to purchase insurance on the one hand and invest in the stock market, undertaking risk, on the other hand? [Eco. (H) III Sem. 2016] Q3. Assuming that different individuals have different preferences towards tisk, explain with the help of total utility of money curve that marginal utility of money will diminish for risk averters and will increase for risk lovers. Q4. An infinitely risk averse individual would accept Rs. 2000 with certainty than face a gamble which offers Rs. 2500 half the time and Rs. 3000 half the time. True or False? Explain with a diagram. Micro Economics 64 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in Ans. The person who is infinitely risk averse views the gamble in terms of its worst-case scenario. Mathematically, this is modeled by the minimum function. For a gamble over choices.a,b,c, ... Infinite risk aversion means the gamble is worth Min(a, b, c, ...). So, in the given question the person has to compare Rs. 2000 with Min(2500, 3000) and he should choose Rs. 2500, ie., statement is false. Numerical Problems QI. An investor rents a stall for the summer and has to choose between two projects, A and B. He can either run an ice-cream parlour (A) or a hot soup and snacks bar (B). if the summer is very hot he can make an estimated profit of Rs. 13,000 from A or Rs. 2,000 from B. If the summer is mild then the estimated profits from A and B are Rs. 2,000 and Rs. 10,000 respectively. If the summer is hot then the respective estimated profits for A and B are Rs. 7,000 and Rs. 6,000. If the probability of a very hot summer is 30% and that for a mild summer is 40% which project should he choose, if his aim is to maximize expected profits. Q2. A risk averse person has Rs. 100 that he can invest in Company A, or in Company B, or in both, and each of the two companies has equal chances of success and failure. He gets double the money if the investment is successful and completely loses his money if it fails. He is considering two investment options, viz., investing half of his money in each company (option 1) or investing all his money in one company (option 2)? Determine which investment he should undertake if the pay- offs from two companies are uncorrelated. [Eco. (H) III Sem. 2014] Q3. An individual has three investment options X, Y and Z; (i) return from option X is of Rs. 1000 with certainty, (ji) return from option Y is Rs. 1500 with probability 1/3 and Rs. 600 with probability 2/3 and (iii) return from option Z is Rs. 1000 with probability 4 and return of Rs. 1000 with probability %4. Calculate the expected return of these investment options. (Eco. (H) IIL Sem. 2018] Q4. Maria is Risk neutral and is thinking about investing in one of the two mutually exclusive projects. Project A requires an investment of Rs. 200 up front. It pays Rs. 600 if it rains, Rs. 800 if it snows, Rs. 400 if it hails and Rs. 0. if it’s sunny. Project B requires an investment of Rs. 300 up front. It pays Rs. 200 if it rains, Rs. 0 if it snows, Rs. 600 if it hails and Rs. 700 if it’s sunny. The probability of each outcome is 0.1 for rains, 0.3 for snow, 0.2 for hail and 0.4 for sun.[Eco. (H) III Sem. 2019] (i) What is the net expected payoff from each project? Which is better for Maria and by how much? (i) Suppose that a meteorologist can forecast the weather with perfect accuracy. What is the value of information for Maria? How much will she pay for the information? QS. Suppose that the two investments have the same three payoff’, but the probability associated with each payoff differs, as illustrated in the table below : Micro Economics 65 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in Probability (Investment P) | Probability (Investment Q) 0.10 0.30 0.80 0.40 0.10 0.30 ()__ Find the expected return and standard deviation of each investment. (ii) Person A, B C has the utility functions Us = 51, Us = V51 and Uc = SF. Which investment A, B and C will choose respectively Q6. The VNM utility function of an individual is « = m2. If her initial wealth is 36, will she accept a gamble in which she wins 13 with probability of 2/3 and lose 11 with probability of 1/3? Q7. Your current wealth is 49. You are considering to participate in a gamble of tossing a fair coin. If the head turns up, you get 15 otherwise you lose 13. If the utility function is U = w"’, would you participate in the gamble? Explain your answer. Q8. A person has a wealth (w) equal to Rs. 1000 and will loose Rs. 600 if his investment in a risky bond is unsuccessful and will gain Rs. 600 if it is successful. The probability that the investment is successful is 0.25 and his utility function is : uw) = wy. [Eco. (H) III Sem. 2013] (a) What is the expected value of his wealth ? (b) What is his expected utility ? (c) __ What is the certainty equivalent of this investment ? Q9. An individual with initial wealth of Rs. 400 has a 20% chance of getting into an accident. If the accident occurs, he will lose Rs. 300 leaving him with Rs. 100. The individual maximizes his VNM utility function which is given as u(w) = vw where w = wealth. Find his expected utility and the certainty equivalent wealth. QI0. An economic agent owns a business that generates an income of Rs. 2,00,000 per day if there is no fire and Rs. 2,000 per day if there is a fire. The probability that there is a fire on the premises is 20%. What is his expected income? If his Von Neumann-Morgenstern utility function is given by U = yy (y is income), what is the certainty equivalent of this busin [Eco. (H) 2009] QUI. Aamir is an expected utility maximizer. His preferences among contingent commodity bundles are represented by the expected utility function : UG, Cz, Mt) = Taf (Cy) + Taf (C2), where f(c) = Ve Aamir’s friend Salman, has offered to bet him Rs. 1,000 on the outcome of the toss of a coin. That is, if the coin comes up heads, Aamir must pay Salman Rs. 1,000 and if the coin comes up Tails, Salman must pay Aamir Rs. 1,000. The coin is a fair coin, so that the probability of heads and the probability of tails are both %. If he doesn’t accept the bet, Aamir will have Rs. 10,000 with certainty. Let event I be “coin comes up heads” and let event 2 be “coin comes up tails”. Let C, be the amount of rupees Aamir has in event | and C; be the amount of rupees Aamir has in event 2. (i) If Aamir accepts the bet then how many rupees will he have in event | and in event 2? (ii) | What is Aamir’s expected utility if he accepts the bet with salman? Micro Economics 6.6 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in (iii) If Aamir decides not to bet, then what will be his expected utility? (iv) Having calculated his expected utility if he bets and if he does not bet, Aamir compares which is higher and makes his decision accordingly. Does Aamir take the bet? Q12. John’s utility function (U) for income I is given as {" for 1<10 uM= ‘ (7-10)* +100 for T>10 (i) Draw John’s utility function (i) He is offered the following choices : Income of zero with a chance 0.25 and income of Rs. 14 with a chance 0.75. Or a certain income of Rs. 10. Will he accept this bet? Why? (iii) He is offered the following choices : Income of zero with a chance 0.25 and income of Rs. 4 with a chance 0.75. Or a certain ineome of Rs. 3. Will he accept this bet? Why? What is his certainty equivalent? Q13. Molly wants to bet that the Indian team will win the series against Australia. A local better is offering odds of 10 to 1 against India (this means for every 1 Re put on the bet, u receive 10 Rs. if India wins). Molly estimates that the probability of India’s win is p = 0.02. If she chooses not to bet she has Rs. 1000 in her purse to go shopping. Her expected utility function is given by pve, +(1— p)e, , where c) and 2 are contingent consumption bundles. What will be Molly’s optimal contingent consumption bundles? How much must she bet? Q14. Patil is a cotton farmer in Maharashtra. He is not certain about the profitability of his next crop. To keep matters simple, assume that there are only two states of nature. The good state occurs with probability 2 and Patil makes a profit of Rs. 10,00,000 in this state. In the bad state his profit is only Rs. 10,000, Patil’s Von- Neumann Morgenstern utility function is Log,,(Y), where Y is Patil’s income. Patil also has the option of entering into a long term contractual arrangement with Reliance Fresh for growing onions and earning Rs. 4,00,000 for sure, irrespective of the state of nature. Should Patil accept the contract offered by Reliance Fresh? QIS. An individual has 3 investment options with the following payoffs : Option A : A certain return of Rs. 560, Option B : A return of Rs. 1,080 with probability 1/3 and return = Rs. 480 with probability = 2/3, Option C : A return of Rs. 1,200 with probability = 1/3 and return = Rs. 240 with probability = 2/3. (a) Compute the expected payoff of the risky options B and C. (b) If Tarun is offered option C, find its certainty equivalent given his utility function: —U = W?, where W = returns from investment. (c) Given that option C is riskier than option B, how would Tarun rank the 3 investment options in order of increasing preferences? Explain. [Eco. (H) I Sem. 2014] Micro Economics 67 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in QI6. A consumer has wealth, W, initially and faces the chance to gain g with probability i or to lose / with probability (1 - m). The utility function is U(y) = Jy where y is the wealth in the different states that can arise. Suppose W = 100, / = 100, g = 0 and x = 1/2. [Eco. (H) III Sem. 2017] (a) Write down the consumer's expected income. (b) Write down the consumer's expected utility. (c) | What is the implication of the above utility function for the individual's attitude to risk ? (4) Calculate and show in a diagram the risk premium. QI7. Lata gets to consume 16 units of food (Fs) if there is ‘ine (probability 3/4) and 4 units of food (Fy) if there is hurricane (probability 1/4). Will she accept a bundle (9, 25) with same probabilities? Find out the equation of indifference curve that passes through the new bundle. Also calculate certainty equivalent and risk premium for the new bundle. Explain your answer with the help of appropriate diagrams if her benefit function for food is given by @ WA=F Gi) WOR) = F'? (ii) W(F)=F. [Eco. (H) IIT Sem. 2020] [nn rarance _} QI. Sudhir lives in Gujarat. His total wealth next year, including his house, will be Rs. 5,00,000. There is a 10% chance that a big earthquake will occur next year and completely destroy his house, valued at Rs. 2,00,000. [DSE MA Ent. Eco. 2007] (i) What is Sudhir’s expected wealth next year if he chooses not to buy house insurance? (i) Suppose Sudhir’s utility function is given by U(W) = WS, where W represents total wealth in thousands of rupees. Is Sudhir risk-averse, risk- loving, or risk neutral? (a) (i) Rs. 4,50,000 and (ii) risk-averse (b) (i) Rs. 4,50,000 and (i) risk-neutral (©) (i) Rs. 4,80,000 and (ii) risk-loving (dG) Rs. 4,80,000 and (ii) risk-averse Q2. Consider an individual A with utility function u()=10Vx, where x denotes the amount of money available to her. Suppose, she has Rs 100. However, she has option of buying a lottery that will cost her Rs 51. If purchased, the lottery pays Rs 351 with probability p, and pays 0 (nothing) with remaining probability. Assume that A is expected utility maximizer. Which of the following statements is correct? Awill [DSE MA Ent. Eco. 2013] (a) _ not prefer to buy the lottery at all as long as p< 1 (b) certainly prefer to buy the lottery as long as p > 0 (©) _ prefer to buy the lottery if and only if p > 51/351 (d)___ prefer to buy the lottery if and only if p > 51/221 Micro Economics 68 By Dheeraj Suri, 9899-192027Prime Academy, www.primeacademy.in For Full Course Video Lectures of ALL Subjects of Eco (Hons), B Com (H), BBE, MA Economics, UGC Net Economics, Indian Economic Service (IES) Register yourself at www.primeacademy.in Dheeraj Suri Classes Prime Academy 9899192027 icro Economics 69 By : Dheeraj SUTi, 9899-192027