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Chapter 2

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21 views4 pages

Chapter 2

Uploaded by

Elias Macher
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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2.

Choice under Uncertainty


1 Expected utility and lotteries
In Economics risk is described by lotteries. Therefore, in order to properly
describe risk, we need to determine all possible outcomes of an event and assign
to each outcome a certain non-negative probability. We will think of outcomes
as being monetary payoffs. The probabilities of the different outcomes must add
up to one. The origin of these probabilities can be objective or subjective. We
will assume that every consumer knows these probabilities, and even stronger,
that they are commonly known.
There are two approaches as to how the consumer decides. Since both the
outcomes and the probabilities matter, we can consider the consumer’s prefer-
ences defined over the outcomes or over the probabilities. The Expected Utility
Theorem will ensure the existence of a utility function of the form
X
ps u(xs )
s

that represent preferences, whether defined on bundles or on lotteries.

1.1 Contingent consumption


First, if we consider the space of state-contingent commodities, a bundle in
RN specifies consumption if state i occurs, with i = 1, ..., N . The 45o line is
interpreted as the certainty line. The consumer has preferences over the set of
state-contingent commodities. If there is only one commodity and two states,
indifference curves may be plotted.
Given a bundle x, the certainty equivalent is the point on the same indif-
ference curve that is also on the certainty line. If the consumer exhibits risk
aversion, then he strictly prefers any convex combination of two bundles on the
same indifference curve than the bundles themselves. In particular, if we connect
any bundle with its certainty equivalent, the individual always prefers a mixture
of the bundle with its certainty equivalent. Finally, the slope of the indifference
curve at the certainty equivalent equals minus the ratio of the probabilities.
In the case of the consumer having preferences over contingent commodities,
the Expected Utility Theorem requires state-irrelevance, independence, and re-
vealed likelihood.

1.2 Lotteries
We will define a simple lottery L as a list L = (p1 , ..., pN ) with pn ≥ 0, ∀n and
P
pn = 1, where pn is interpreted as the probability that outcome n occurs.
n
The consumer has a rational preference relation < over all possible lotteries.
As in the case of choice under certainty, there is some utility function U : £ → R,

1
from the space of lotteries to the set of real numbers, that summarizes such
preference relation. This utility function has an expected utility form if there
is an assignment of numbers (u1 , ..., uN ) to the N outcomes such that for every
simple lottery L, we have

U (L) = u1 p1 + ... + uN pN

i.e. it is additively separable over the outcomes and linear in probabilities.


A utility function U with the expected utility form is called a von Neumann-
Morgenstern expected utility function. The Expected Utility Theorem says
that if the rational preference relation < on lotteries satisfies continuity and
independence, then < admits a utility representation of the expected utility
form. This implies that we can assign a number un to each outcome n such that
for any two lotteries L = (p1 , ..., pN ) and L0 = (p01 , ..., p0N ) we have that
N
X N
X
L < L0 if and only if un pn ≥ un p0n
n=1 n=1

Example 1 Allais’ Paradox. Assume there are three possible monetary prizes:
$2.5m, $0.5m, and $0. The individual must choose between the following two
lotteries:
L1 = (0, 1, 0) and L01 = (.10, .89, .01)
and typically people will prefer lottery L1 . On the other hand, if the individual
chooses between

L2 = (0, .11, .89) and L02 = (.10, 0, .90)

then he will choose L02 . These choices are not consistent with expected utility.
If the individual prefers L1 , this means that

u0.5 > .1u2.5 + .89u0.5 + .01u0

and adding and substracting .89u0 − .89u0.5 on both sides yields

.11u0.5 + .89u0 > .1u2.5 + .9u0

and thus the individual should prefer L2 to L02 , if he had a von Neumann-
Morgenstern utility function.

2 Attitudes towards risk


We will consider risky alternatives whose outcomes are amounts of money. Here
we will deal with an infinite number of outcomes, whose probabilities are de-
scribed by some distribution function F : R → [0, 1]. Thus, both money and
outcomes are continuous variables. For any x, F (x) is the probability that the
realized payoff is less than or equal to x. The lottery space is the set of all
distribution functions over nonnegative amounts of money.

2
This way, the vNM utility function can be written as
Z
U (F ) = u(x)dF (x),

where u(x) is the Bernoulli utility function.


The individual is risk-averse if
Z
u(x)dF (x) ≤ u (xdF (x)) ∀F (·),

and the individual is risk-neutral if it holds with equality. Notice that this is a
direct application of Jensen’s inequality, since u(·) is a concave function in the
case of a risk-averse person. Because of concavity, the utility gain from an extra
dollar is smaller than the utility loss of losing one dollar.
The certainty equivalent of a lottery F is the amount of money for which the
individual is indifferent between the gamble F and the certain amount c(F, u),
i.e. Z
u(c(F, u)) = u(x)dF (x)

There are two relevant measures for risk aversion. First, the Arrow-Pratt
coefficient of absolute risk aversion at x is defined as
u00 (x)
a(x) = − ,
u0 (x)

and it informs us about the concavity of the Bernoulli utility function. Further-
more, the risk premium may be approximated by the expression
1
a(x)var(x).
2
Alternatively, the coefficient of relative risk aversion is

u00 (x)
r(x) = −x .
u0 (x)

Example 2 The demand for insurance. Suppose a consumer initially has mon-
etary wealth W. There is some probability p that he will lose an amount L. He
can purchase insurance that will pay him q dollars in the event of a loss. The
cost is π per dollar of coverage. The consumer wishes to determine how much
coverage to purchase. His problem is

maxpu(W − L − πq + q) + (1 − p)u(W − πq),


q

which implies, from its first-order condition, that

u0 (W − L + (1 − π)q ∗ ) 1−p π
= .
u0 (W − πq ∗ ) p 1−π

3
On the other hand, the expected profit of the insurance company is

(1 − p)πq − p(1 − π)q

If perfect competition in the insurance company forces profits to zero, then


π = p, and the insurance firm charges an actuarially fair premium. In this case,
the first order condition becomes

u0 (W − L + (1 − π)q ∗ ) = u0 (W − πq ∗ ),

which implies that if the consumer is strictly risk-averse, i.e. the second deriva-
tive is negative, then he will fully insure, i.e.

W − L + (1 − π)q ∗ = W − πq ∗ ⇒ q ∗ = L.

Example 3 A consumer has an expected utility function u(w) = ln w. He is


given the opportunity to bet on the flip of a coin that has a probability π of
coming up heads. If he bets x, he gets w + x if heads comes up and w − x if tails
comes up. The optimal x as a function of π is determined by his maximization
problem:
max π ln(w + x) + (1 − π) ln(w − x).
0≤x≤w

We do not have to worry about the case x > w, since, if 1 − π > 0, then
the expected loss would be infinite. The two relevant cases are x = 0 and x > 0.
The first-order condition is
π 1−π
− ≤ 0.
w+x w−x
Then, if x > 0,
π 1−π
= ⇒ x = (2π − 1),
w+x w−x
and if x = 0,
π 1−π 1
< ⇒π< .
w w 2

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