Walter Nicholson

Amherst College

Christopher Snyder
Dartmouth College

PowerPoint Slide Presentation | Philip Heap, James Madison University

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 4
CHAPTER

Uncertainty

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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 Chapter Preview
• We now want to introduce uncertainty into economic choices.

• Three issues to address:

1. How does uncertainty affect people’s decisions?

2. Why do people generally dislike risk?

3. What can people do to reduce or avoid risk?

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ch. 4 • 3
 Probability and Expected
Value
• Probability:

– The relative frequency with which an event occurs.

– What is the probability of flipping a heads; rolling a 5 on a die?

• Expected value the average outcome from an uncertain gamble.

• Fair gamble is a gamble with an expected value of zero.

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ch. 4 • 4
 Probability and Expected
Value
• Let P1 = ½ and P2 = ½ be the probability that event 1 and 2 occur.
If event 1 occurs you win X1 = $10, and if event 2 occurs you lose
X2 = -$1. What is the expected value of the gamble?

– Expected value = P1X1 + P2X2

– ½ x $10 + ½ x -$1 = $4.50

• How much would you be willing to pay for the right to play this
gamble?

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 Risk Aversion

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 Diminishing Marginal Utility
of Income
What happens to utility as income increases?

Utility As income rises, utility rises but at a diminishing rate.

Income
20 35 50 ($1,000’s)

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 Diminishing Marginal Utility
of Income
U3 is the utility from $35,000
Utility
Would you take a fair gamble
with a 50:50 chance of
winning or losing $5,000?
U3
U2 Don’t take gamble: can get a
sure U3 or an expected U2

Income
20 30 35 40 50 ($1,000’s)

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ch. 4 • 8
 Diminishing Marginal Utility
of Income
Utility
What about a fair gamble
with a 50:50 chance of
winning or losing $15,000
U3
Don’t take gamble: can get a
U1 sure U3 or an expected U1

Income
20 30 35 40 50 ($1,000’s)

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ch. 4 • 9
 Willingness to Pay to Avoid
Risk
Utility
How much would you be
willing to pay to avoid the first
gamble?
U3
U2 To get U2 you would need
$33,000.
So you would pay $2,000 to
avoid the gamble.

Income
20 30 33 35 40 50 ($1,000’s)

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ch. 4 • 10
 Degrees of Risk Aversion

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 How To Reduce Risk and
Uncertainty

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 Reducing Risk w/ Insurance
• Suppose you make $35,000 per year. There is a 50% chance you
will incur medical bills of $15,000.

Utility
Without insurance your expected utility is U1

U1

Income
20 27.5 35 ($1,000’s)

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ch. 4 • 13
 Reducing Risk w/ Insurance
• Fair insurance: insurance for which the premium is equal to the
expected value of the loss.
The premium would be
Utility
$7,500 (35 – 27.5).

A policy that costs $7,500

U2 would allow the person to
obtain a certain utility of U2.
U1
But an insurance company
would never offer fair
insurance. Why?

Income
20 27.5 35 ($1,000’s)

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ch. 4 • 14
 Reducing Risk w/ Insurance
• How much would this person be willing to pay for insurance?

With no insurance, they get an

Utility
expected utility of U1.

They can get a certain utility, U1

U2 with $24,000 income.

U1
Therefore, they would be
willing to pay up to $11,000 to
get insurance.

Income
20 24 27.5 35 ($1,000’s)

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ch. 4 • 15
 Reducing Risk w/ Insurance

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ch. 4 • 16
 Reducing Risk w/
Diversification
• What is diversification? How does it allow you to spread risk?

• Suppose You have $35,000 to invest $15,000 in Company A

and/or B. One share in each company costs $1.

• At the end of the year there is a 50:50 chance that the share price
will rise to $2 and a 50:50 chance it will fall to $0.

• What is the expected value of your income if you put all your
money in one company?

– $35k since you have a 50:50 chance of winning/losing $15k

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ch. 4 • 17
 Reducing Risk w/
Diversification
• Now suppose you put half of your money in each company.

Final Income Company B

Poor Good
Poor $20,000 $35,000
Company A
Good $35,000 $50,000

• There is a 25% probability that each outcome occurs.

• Like before, your expected value is $35,000

• What’s the difference?

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ch. 4 • 18
 Reducing Risk w/
Diversification
• The difference is your expected utility
Utility
You get U1 if you invest in
only one company.

But you can get U2 if you

U2
invest in both companies.
U1
So by diversifying you can
increase your utility.

Income
20 35 50 ($1,000’s)

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ch. 4 • 19
 Reducing Risk w/ Flexibility

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 Reducing Risk w/ Flexibility
• Suppose you can buy one of three coats.

COAT BITTER COLD MILD

PARKA 100 50
WINDBREAKER 50 100
2-in-1 100 100

• At equal prices, the 2-in-1 coat is clearly better since it provides

more options.

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ch. 4 • 21
 Reducing Risk w/ Flexibility

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 Reducing Risk w/ Information
• Why is information valuable? What are the costs and benefits?

COAT BITTER COLD MILD

PARKA 100 (150) 50 (0)
WINDBREAKER 50 (0) 100 (150)

• 2-in-1 coat expensive. Parka and windbreaker sell for same price.

• If knew for certain that it will be bitter cold you buy a Parka and
gain 25 utils.

• In more extreme case the gain would be 75 utils.

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ch. 4 • 23
 Reducing Risk w/ Information
COAT BITTER COLD MILD
PARKA 100 (150) 50 (0)
WINDBREAKER 50 (0) 100 (150)

• Would a risk neutral person gain from additional information?

• Assume the payoffs in the table represent $ values rather than utils.

• The risk neutral person would gain either $25 or $75 from a perfect
forecast.

• Need to compare the benefits and costs of the information.

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ch. 4 • 24
 Reducing Risk w/ Information
• What determines the amount of information someone will acquire?

• Costs: partly determined by skills and or experiences.

• Preferences: do you care about getting a good deal; do you like to

bargain.

• Since costs and preferences are likely to differ the level of

information people acquire will differ.

• Is procrastination a virtue or a curse?

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 Pricing of Risk in Financial
Assets

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 Pricing of Risk in Financial
Assets
Return C AC is the market line

It shows different assets that can

B be created by mixing the risk-free
asset A and different risky assets.

Note that any asset on AC

provides the greatest expected
Risky assets return for a given amount of risk.
A
Risk-free asset
Risk

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ch. 4 • 27
 Pricing of Risk in Financial
Assets
U H
UM
UL C
Return How do different investors decide
which asset on AC they buy?

B Different investors will choose an

asset on the market line depending
on their risk tolerance.

Note that the flatter the

indifference curve the higher the
A degree of risk tolerance.
Risk-free asset
Risk

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ch. 4 • 28
 Two State Model
• Want to develop a model that will tie everything we’ve discussed
together.

• Assume there are two possible outcomes or states of the world.

• In each state, the individual’s consumption is either C1 or C2.

• There are four possible choices (gambles): A, B, D and F.

• Want to see how an individual decides which gamble to choose.

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ch. 4 • 29
 Two State Model

C2
Certainty line:
C1=C2
Which gamble will the person
choose?

The individual will choose gamble B

D since it lies on the highest expected
B utility curve.
F EU3
CA2 A EU2
EU1
C1
CA1

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 Two State Model and Risk
Aversion
Risk aversion is captured by the convexity of the
C2 indifference curves

Faced with a choice between gambles A, B and D,

an individual would prefer D
B
D provides a balance in consumption: “averages
are preferred to extremes”
D

EU3
A EU2
EU1
C1

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 Two State Model and Risk
Aversion
What do these two indifference curves tell you?
C2
EU1 is an indifference curve for a risk averse
person.

EU2 is an indifference curve for a risk neutral

person.

EU1
EU2
C1

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ch. 4 • 32
 Two State Model and
Insurance
C2
Suppose an accident can occur in state 2
but not state 1

A is the situation with no insurance

D With fair insurance a person can move to

CD2 point D: pay CA1 - CD1 to get CD2 – CA2
EU3
EU2
CA2 A EU1

C1
CD1 CA1

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ch. 4 • 33
 Two State Model and
Insurance
C2 Even if only partial insurance is available,
the person is better off with insurance
than without.
C1=C2
The person can move from A to B.

D Like before the amount they pay in C1 <

CD2
the amount the gain in C2.
EU3
B
EU2
CA2 A EU1

C1
CD1 CA1

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ch. 4 • 34
 Two State Model and
Diversification
An investor can put all their money in asset A or 1
all their money in asset A2
C2
If they are indifferent, A1 and A2 lie on the same
EU curve.

A2 By investing in a mix of both assets the investor

can attain any point on a line between A1 and A2

B So by diversifying they can receive greater

expected utility.

EU2
A1 EU1

C1

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ch. 4 • 35
 Summ
ary
• When individuals face uncertain situations they consider their
expected utility.

• If individuals have diminishing marginal utility for income, they

are risk averse and will refuse fair gambles.

• Insurance allows risk averse individuals to avoid participating in

fair gambles.

• Risk may also be reduced with diversification, buying options, or

acquiring better information.

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ch. 4 • 36
 Summ
ary
• Individuals will compare expected return and risk when deciding
what financial assets to buy.

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ch. 4 • 37