Addis Ababa University

School of Commerce
Department of Economics

Microeconomics

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 Chapter Two
Risk and Uncertainty
• What is uncertain in economic systems?
• tomorrow’s prices
• future wealth
• future availability of commodities
• present and future actions of other people.

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Describing Risk
• Risk - situation in which the likelihood of each
possible outcome is known or can be estimated and
no single possible outcome is certain to occur.
• Uncertainty- occurs if each action has as its
consequence a set of possible specific outcomes,
the probabilities of which are unknown.
• A probability is a number between 0 and 1 that
indicates the likelihood that a particular outcome
will occur.
• Expected value and Measure of variability is used
to describe and compare risky choice.

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Expected Value(payoff)
• The expected value, E(x), is the value of each
possible outcome times the probability of that
outcome:

E( X ) = Pr1 ( X1 ) + Pr2 ( X 2 )
Where Pr1 and Pr2 probabilit ies of X1 and X 2 will occur

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 Expected payoff
• Let x1, x2, … , xN be the N possible payoffs of a risky
decision, and
• Let p1, p2, … , pN be the probabilities of those
payoffs
• Then the expected Value(payoff) of the risky
decision is
E(X) = p1 . x1 + p2 . x2 + … + pN . xN
• This is what the average payoff would be if the risky
decision is, hypothetically, repeated numerous times

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 Example
TABLE 2.1 Income from Sales Jobs
OUTCOME 1 OUTCOME 2 Expected
Probability Income ($) Probability Income ($) Income ($)

Job 1: Commission .5 2000 .5 1000 1500

Job 2: Fixed Salary .99 1510 .01 510 1500

12/1/2024 Micro I Slides Guta AAU 6

 Variance: a measure of riskiness
• The variance of a risky decision is defined as
Variance = p1 . (x1 – E(x))2 + p2 . (x2 – E(x))2 + … +
pN . (xN – E(x))2
• Note that if the payoffs of a risky decisions, P1, P2, … ,
PN, are all close to the expected payoff, EP, then the
variance is small.
• And this is precisely a case in which the risk is small,
because the payoffs, though unpredictable, are all
quite similar.
• Therefore, the variance is an excellent measure of risk.
• The square root of the variance is called the standard
deviation.
• It is also a popular measure of the riskiness of a risky
decision.
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• Example:- Mr.X, a promoter, is to schedule an outdoor or indoor concert for tomorrow.
• How much money (in thousands) he’ll make depends on the weather.
• If it doesn’t rain, his profit or value from the outdoor concert is X1 = $15 or indoor gets $10.
• If it rains, he’ll have to cancel the outdoor concert and he’ll lose X2 = −$5, which he must pay the
band. On the other hand gets $0 from the indoor.
• He knows that the weather department forecasts a 50% chance of rain.
• Find the expected value , the variance and standard deviation and determine which of the
alternatives he choose.

E ( X ) = Pr1 ( X 1 ) + Pr2 ( X 2 )
E ( X ) = 0.5(15) + 0.5(−5)
E ( X ) = 7.5 − 2.5 = 5

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Preferences Towards Risk
• Consumer obtain utility choosing among risky
alternatives
• We measure payoffs in terms of utility rather than
dollars
• Expected utility ,E(U) - the probability-weighted
average of the utility from each possible
outcome.
• For example, E(U) from the N payoffs is given by:
• E(U) = p1 . U(x1 )+ p2 . U(x2 )+ … + pN . U(xN )

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Expected utility

Utility, U
U(Wealth)
c
U($70) = 140
0.1U($10) + 0.9 U($70) = 133 f
d
U($40) = 120

0.5U($10) + 0.5 U($70) =

e
U($26) = 105 b

a
U($10) = 70

0 10 26 40 64 70 Wealth, $

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Different Preferences towards Risk
People differ in their willingness to bear risk:
• Risk averse- prefer certain income to risky
income with same expected value
• Risk loving - prefer risky income to certain
income with same expected value
• Risk neutral- indifferent between certain
income and risky income with same expected
value

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 Preferences Under Uncertainty
• Think of a lottery.
• Win $90 with probability 1/2 and win $0 with
probability 1/2.
• U($90) = 12, U($0) = 2.
• Expected utility is

1 1
E(U) =  U($90) +  U($0)
2 2
1 1
=  12 +  2 = 7.
2 2

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Preferences Under Uncertainty
• Think of a lottery.
• Win $90 with probability 1/2 and win $0 with
probability 1/2.
• Expected money value of the lottery is

1 1
E(M) =  $90 +  $0 = $45.
2 2

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 Preferences Under Uncertainty

• E(U) = 7 and E(M) = $45.

• U($45) > 7  $45 for sure is preferred to the lottery  risk-aversion.
• U($45) < 7  the lottery is preferred to $45 for sure  risk-loving.
• U($45) = 7  the lottery is preferred equally to $45 for sure  risk-
neutrality.

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Different Preferences towards Risk
Utility
U($45) > E(U)  risk-aversion.
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MU declines as wealth
U($45)
rises.

E(U)=7

$0 $45 $90 Wealth

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Different Preferences towards Risk
Utility U($45) < E(U)  risk-loving.

12 MU rises as wealth
rises.

E(U)=7

U($45)
2

$0 $45 $90 Wealth

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Different Preferences towards Risk
Utility U($45) = E(U)  risk-neutrality.

12 MU constant as wealth
rises.

U($45) =
E(U)=7

$0 $45 $90 Wealth

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Risk premium
• Risk premium - the amount that a risk-averse
person would pay to avoid taking a risk
• The risk premium of a risky bundle is the
difference between its expected consumption and
the consumer’s certainty equivalent
• Risk premium = Expected payoff - Certainty equivalent
 The magnitude of risk premium depends on the risky
alternatives that the person faces

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Example
• Case1: Suppose Mr.X earn birr 16,000 and
offered anew but risky job of getting birr10,000
and birr 30,000 each with probability of 0.5.
calculate the maximum amount of risk premium
paid if he want to insure this job
• Case2: Suppose Mr.X earn birr 10,000 and
offered anew but risky job of getting birr40,000
and birr 0 each with probability of 0.5. calculate
the maximum amount of risk premium paid if he
want to insure this job

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 Risk premium
Utility

c U(Income)
20
18
f
16 d

e
14 b

a
10 g

0 16 20 30 40 Income
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Risk premium

Risk premium 20
Example 1
Suppose Alemtu is currently earning annual income of
birr 9,000. She now faces an offer of a risky job which
would get either Birr 12,000 with probability of 0.5 or Birr
6,000 with probability of 0.5. Alemitu’s utility function is
given by the following schedule :

a) Calculate the expected utility of the new job

Income Utility b) What is Alemetu’s attitude towards risk?
Explain
6,000 10 c) Calculate the maximum premium that Alemetu
8,000 13 pay to insure the risky job
9,000 15
12,000 16

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Example 2
• The utility function of Feven is given as U=W1/2.
Suppose she is currently earning an income of
birr 62.5 per day. She now faces an offer of a
risky job which would get either Birr 25 with
probability of 0.5 or Birr 100 with probability of
0.5.
a) Calculate the expected utility of the new job
b) What is her attitude towards risk? Explain
c) Calculate the maximum premium that she pay to
insure the risky job.
 Numerical Examples
1. The utility function of a consumer is given as
U=2W1/2 with an initial endowment of
60,000Birr. If he is involved in a game of fair
gamble which could lead to a win/loss of
40,000Birr, determine the attitude of this
consumer towards risk.
2. The utility function of a consumer is given as
U=W1/2 with an initial endowment of 900Birr.
If he is involved in a game of fair gamble which
could lead to a win/loss of 500Birr, determine
how much the consumer is willing to pay to
avoid risk.

12/1/2024 Micro I Slides Guta AAU 23

Risk Reducing Mechanisms
• Diversification
• Insure
• Invest on Information

Diversification is the practice of undertaking many

risky activities, each on a small scale, rather than a
few risky activities on a large scale
“Don’t put all your eggs in one basket”
Dividing investments among many activities reduces risk

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Invest on Information
• value of complete information is difference
between the expected value of a choice when there
is complete information and the expected value
when information is incomplete
• Value of information = expected value with complete
information minus expected value with uncertain
information

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----- End of Chapter Two ------