Mr.

Mataa Wakunmelo

Choicc under Uncertainty

If the consumer has reasOnable prelerences about consumption in different circumstanccs,
hen we will be able to usc a utility function to
describe thesc prelerences.
How a person valucs consumption in onc state as compared to another will depcndonthe
Probabilin' that the state in question willactually occur.
or his reason, we will write the utility function as depcndingon the
on the consumption levels. probabilitics as wen

uppose that we are considering two mutually cxclusive states such as rain and
shine
belTand C2 represent consumption in states I and 2, and let I, and I, be the probab1lities
that state 1or state 2 actually
occurs.
IT thetwO states are mutually exclusive, sothat only one of them
can happen, then 2 = T=
T1. But we'll generally write out both probabilities just to keep things looking
symmetric.
Given this notation, we can write the utility function for consumption in states I and 2 as U
(C1. C2. I1, 12 ).
This is the function that represents the individual's preference over
consumption in each state.
Wecan usenearly any of the examples of utility functions that we've seen up until now in the
context of choice under uncertainty. One nice example is the case of perfect substitutes.
Here it is natural to weight each consumption by the probability that it will occur. This gives
us a utility function of the form:

U(C1,C2, T, T;) = 4C1+ ,C2. (1)

In the context of uncertainty, this kind of expression is known as the expected value. It is
just the average level of consumption that you would get.

Another example ofa utility function that might be used to examine choice under uncertainty
is the Cobb-Douglas utility function:

UC1,C2, T, 1- ) = C"C,1-n, ..(2)

Here the utility attached to any combination of consumption bundles depends on the pattern
of consumption in a nonlincar way.

We can take a monotonic transformation of utility and still represent the same preferences, It
turns out that the logarithm of the Cobb-Douglas utility will be very convenient in what
follows. This will give us a utility function of the form

lnU(C1, C2, I, I;) = TI4lnC1 + TizlnC2.. (3

Mr. MataaWakumelo

Expected Utility
This says that utility can be
cach state,, v(cl) and wrillen as a weighted sum of somefunction of consumplion in
v(c2). where the weights are givenbythe probabililies.
U(C1, C2, T1,Nz) =
The expression on the
nV(C1) + ,v(C2).... ..(4)
the pattern of right hand side representsthe average utility, orthe cxpected utility, of
consumption (cl, c2)
For this
expected
reason, we reler to a utility
utility funetion, or, function with the particular form described here as an
When we say that a
sometimes, a von Neumann-Morgenstern utility function
function. or that the consumer's preferences can be represented by an expected utility
We can
choose a utilityconsumer's preferences have the expected utility property, we mcan that
function that has the additive form described above
Risk Aversion
Suppose that a consumer currently has $10 of
glves hima 50 percent
probability of winningwealth and is
contemplating a gambie unal
$5 and a 50 percent
His wealth will
therefore be
probability of losing .
probability random:
and a 50 percent he has a
of ending up with50 percent probability of ending up with $5
$15.
What is the expected value of
his wealth? -$10
What is his expected
utility?
1

u($15) +;u($5).
..5)
R1SK
Us)
(aene)
U(6)

For Byessa ConSumor

w-ete
the eeclco

Note that in this diagram thc expected utility of wealth is less than the utility of the
wealth. That is expected
MI. Mataa Wakumelo

15+'s)>s)+u6). (6)

In this case we sav that thc consumer is risk averse since he prefersto havethe cxpected
value of his wealth rather than facethe gamble. Ihe risk-aversc consumer has a conca
utility funcion-its slope gets Ilatter as wealth is inereascd.

BUTifaconsumer prefers arandom distribution of wcalth to itsexpected valuc. i wmcn

casc we sav that the consumer is a isk lover.

V(s)

Vlet
pectes

The risk-loving consumer has aconvex utility function-its slopcgets stecper as wealth
increases.
Thus the curvature of the utility function measures the consumer's attitude toward risk.
In general. the more concavethe utility function, the more risk averse the consumer will be,
and the more convex the utility function, themore risk loving the consumer will be.

The intermediatecase is that of alincar utility function. Here the consumer is risk neutral:
Theexpected utility of wealth is the utility of its expected value. In this case the consumer
doesn't care about the riskiness of his wcalth at all-only about its expected value.
Example: Insurance

Suppose that an individual initially has $35,000 worthof assets, but there is a possibility that
he may lose $10,000. Suppose that theprobability of thisevent happening is p 0.01. Then
the probabilitydistribution the person is lcing is a l pereent probabilityof having $2S,000
of asscts, and a99 percent probability of laving $35,000.,
Mr. Mataa Wakumelo

lnsurance offers a way to change this probability

distribution..
Suppose that there is an insurance contract that will pay the person $100 if the loss occurs in
exchange for a $1 premium.
Of course the premium must be
paid whether or not the loss 0ccurs.

psOn decides to purchase $10.000 dollars

vase ne Will have a lpercent chance ofhaving (3sofinsurance.
it will cost him $100. In this
000 of other assets - $10,000 loss +
$10,000 payment from the
insurance payment - $100insurance premium - $34,900)
and a 99 percent
chance of having ($35,000 of: assets - $100 insurance premium =$34,900).
Thus, the consumer ends up with the same
insured against loss. wealth no matter what happens. He 1S now 1ully

n general, if this person

purchases K dollars of
he will face the gamble probability 0.01 of insurance and has to pay a premium YA,
getting $35,000 - yK getting $25,000 +K-yK probability 0.99 of then
What kind of insurance will this
person choose?
Well, that depends on his preferences. He
a lot of insurance, or he might be very conservative and choose to
might like to take risks and not purchase purchase
any insurance all.
at
People have different preferences over probability
have different preferences over the distributions in the same way that they
consumption of ordinary goods
Let's describe the insurance purchase in terms of the
using. indifference-curve analysis we've been
Your endowment of contingent consumption is $25,000 in the
and $35,000 in the "good" state if it doesn't occur. "bad" state-if the loss occurs
Insurance offers you a way to move away from this endowment point. If you
dollars' worth of insurance, you give up yK dollars of purchase K
state in exchange for K- yK dollars of consumption consumption possibilities in the good
possibilities in the bad state.
Thus the consumption you lose in the good state, divided by the extra
in the bad state, is consumption you gain
YK
ACH K-yK ..(7)
This is the slope of the budget line through your endowment. It is just as if the price of
consumption in the good state is 1-y and the price in thebad state is y,
 MI Mataa Wakumelo

might have for contingent consumption.

inodiferencc curvesthat a person
inthe
We can drau shape: this means that
indifference curvesto have a convex state than alarge
vey natural
for consumptionin cach
agatitt tn a constant amount of
Her
wouldrather have other
amount in the
th pxrson and a loW
amount tti one statc look at the
in cach state of nature, we can
consumption
curves for
(iven thc ndtfierencc
insurance to purchase.
choscx of how much marginal rate ofsubstitution
characterizcd by a tangency condition:the price atwhich youcan
the
Ax UsuEl thus wilbe in cach state of natureshould be equal to
betwoct coIsunption in thosc states.
Iradc ofl consumption