CHAPTER 7 - UNCERTAINTY AND CONSUMER BEHAVIOR

Key Concepts and Topics

• Describing Risk
• Preferences Toward Risk
• Reducing Risk
• The Demand for Risky Assets

Describing Risk
• To measure risk we must know:
1. All of the possible outcomes
2. The probability or likelihood that a given outcome will occur
• Interpreting Probability
– Objective probability
 Observed frequency of past events
– Subjective probability
 Perception that an outcome will occur
 Influenced by different information or different abilities to process the
same information – based on judgment or experience
• 2 measures to help describe and compare risky choices
1. Expected value
2. Variability
• Expected Value
– Probability-weighted average of the payoffs or values associated with all
possible outcomes
 measures the central tendency; the payoff or value expected on average

– Example: Investment in offshore drilling exploration: 2 possible outcomes

 Success – the stock price increases from $30 to $40/share
 Failure – the stock price falls from $30 to $20/share
 Objective Probability
– 100 explorations: 25 successes and 75 failures
– Probability of success = 0.25 and probability of failure = 0.75
– EV = Pr(success)(value of success) + Pr(failure)(value of failure)
= 0.25($40/share) + 0.75($20/share) = $25/share

Source: Pindyck and Rubinfeld (2018), Microeconomics, 9th Ed., Pearson Prentice Hall. 1
 – In general, for n possible outcomes:
E(X) = Pr1X1 + Pr2X2 + … + PrnXn
where X1, X2, … Xn = payoffs of possible outcomes
Pr1, Pr2, … Prn = probabilities of each outcome
• Variability
– Extent to which possible outcomes of an uncertain event differ
– How much variation exists in the possible choices
– Example: Suppose you are choosing between two part-time sales jobs that
have the same expected income ($1,500)

Outcome 1 Outcome 2
Pr Income Pr Income
Job 1: Commission 0.5 $2,000 0.5 $1,000
Job 2: Fixed salary 0.99 $1,510 0.01 $510
E(X1) = 0.5($2,000) + 0.5($1,000) = $1,500
E(X2) = 0.99($1,510) + 0.01($510) = $1,500
 Same expected values, but different variability
 Greater variability from expected values signals greater risk
 Variability comes from deviations in payoffs
– Difference between expected payoff and actual payoff

Deviations from Expected Income ($)

Outcome 1 Deviation Outcome 2 Deviation
Job 1 $2,000 $500 $1,000 –$500
Job 2 $1,510 $10 $510 –$990

 Average deviations are always zero so we must adjust for negative

numbers by taking the squares of the deviations
 Measure variability with standard deviation, 
– Square root of the weighted average of the squares of the deviations
(variance, 2)
– Measures how variable your payoff will be
– More variability means more risk
– Individuals generally prefer less variability – less risk

Source: Pindyck and Rubinfeld (2018), Microeconomics, 9th Ed., Pearson Prentice Hall. 2
 – The standard deviation is written:
  Pr1 ( X 1  E ( X )) 2  Pr2 ( X 2  E ( X )) 2

 Standard deviations of the two jobs are:

 1  .5(250,000)  .5(250,000)  250,000  500
 2  .99(100)  .01(980,100)  9,900  99.50

 1 > 2, Job 1 is therefore the riskier alternative. Choose Job 2.

– Example modified: Suppose we add $100 to each payoff in Job 1
 Job 1: expected income $1,600 and a standard deviation of $500
 Job 2: expected income $1,500 and a standard deviation of $99.50
– Which job should be chosen?
o Depends on the individual
o Some may be willing to take risk with higher expected income
o Some will prefer less risk even with lower expected income

Preferences Toward Risk

• Evaluate risky alternatives by measuring payoff in terms of utility
– A consumer gets utility from income
– Example:
 A person is earning $15,000 and receiving 13.5 units of utility from the
job
 She is considering a new, but risky job
– 0.50 chance of $30,000 and 0.50 chance of $10,000
– Utility($30,000) = 18 and Utility($10,000) = 10
– To evaluate the new job, she must compare the expected utility from
the risky job with current utility of 13.5
 Expected utility of the risky option is the sum of the utilities associated
with all her possible incomes weighted by the probability that each
income will occur
E(U) = (Pr. of Utility 1)*(Utility 1) + (Pr. of Utility 2)*(Utility 2)
= 0.5*U($10,000) + 0.5*U($30,000)
= 0.5(10) + 0.5(18) = 14
– E(U) of new job is 14 which is greater than the current utility of 13.5
and therefore preferred

Source: Pindyck and Rubinfeld (2018), Microeconomics, 9th Ed., Pearson Prentice Hall. 3
• People differ in their preference toward risk
– People can be risk averse, risk neutral, or risk loving
• Risk Averse
– A person who prefers a certain given income to a risky income with the
same expected value
– Diminishing marginal utility of income
– Most common attitude towards risk
 Ex: Market for insurance

– Example:
 A person can have a $20,000 job with 100% probability and receive a
utility level of 16
 The person could have a job with a 0.5 chance of earning $30,000 and a
0.5 chance of earning $10,000
 Expected Income of risky job
E(I) = (0.5)($30,000) + (0.5)($10,000) = $20,000
 Expected Utility of risky job
E(U) = (0.5)(10) + (0.5)(18) = 14
 Both jobs have the same expected income but different expected utilities
– Risk averse individual would choose the certain job for its greater
utility
 Risk averse person’s losses (decreased utility) are more important than
risky gains
– Risk averse utility function
E
Utility 18 Level of utility increases as
D
16 income increases – marginal
C utility is diminishing
14 F
A A risk-averse person prefers a
certain income of $20,000 to
10 an uncertain expected income
of $20,000

0 10 16 20 30 Income ($1,000)

• Risk Neutral
– A person is indifferent between a certain income and an uncertain income
with the same expected value
– Constant marginal utility of income

Source: Pindyck and Rubinfeld (2018), Microeconomics, 9th Ed., Pearson Prentice Hall. 4
 – Expected utility for risky option is the same as for certain outcome
E(I) = (0.5)($10,000) + (0.5)($30,000) = $20,000
E(U) = (0.5)(6) + (0.5)(18) = 12
– This is the same as the certain income of $20,000 with utility of 12
Utility 18
Level of utility increases as
income increases –
marginal utility is constant
12
A risk-neutral person is
indifferent between certain
events and uncertain events
6 with the same expected
income

0 10 20 30 Income ($1,000)

• Risk Loving
– A person prefers an uncertain income to a certain income with the same
expected value
 Examples: Gambling, some criminal activity
– Increasing marginal utility of income
– Expected value for risky option
E(I) = (0.5)($10,000) + (0.5)($30,000) = $20,000
E(U) = (0.5)(3) + (0.5)(18) = 10.5
– Certain income is $20,000 with utility of 8
– Risky alternative is preferred

Utility 18
Level of utility increases as
income increases –
marginal utility is increasing

10.5 A risk-loving person prefers

uncertain events to certain
8 events with the same
expected income

0
10 20 30 Income ($1,000)

• Risk Premium
– The maximum amount of money that a risk-averse person would pay to
avoid taking a risk
– Depends on the risky alternatives the person faces
Source: Pindyck and Rubinfeld (2018), Microeconomics, 9th Ed., Pearson Prentice Hall. 5
 – Example:
 A person has a 0.5 probability of earning $30,000 and a 0.5 probability of
earning $10,000
 The expected income is $20,000 with expected utility of 14
Utility
G
20
18 The risk premium is $4,000
C E because a certain income of
14
F $16,000 gives the person
A the same expected utility as
10 the uncertain income with
expected value of $20,000

0 10 16 20 30 40 Income ($1,000)

 Point F shows the risky scenario – the utility of 14 can also be obtained
with certain income of $16,000
 This person would be willing to pay up to $4,000 (20 – 16) to avoid the
risk of uncertain income
– Can be shown graphically by drawing a straight line (CF) between the
two points

• Risk Aversion and Income

– Variability in potential payoffs increases the risk premium
– Example:
 A job has a 0.5 probability of paying $40,000 (utility = 20) and a 0.5
probability of paying 0 (utility = 0)
 The expected income is still $20,000, but the expected utility falls to 10
E(U) = (0.5)U($0) + (0.5)U($40,000) = 0 + 0.5(20) = 10
 The certain income of $20,000 has utility of 16
 If a person must take new job, his utility will fall by 6
 He can get 10 units of utility by taking a certain job paying $10,000
 The risk premium, therefore, is $10,000 (i.e. he would be willing to give
up $10,000 of the $20,000 and have the same E(U) as the risky job)
– The greater the variability, the more the person would be willing to pay to
avoid the risk and the larger the risk premium

Source: Pindyck and Rubinfeld (2018), Microeconomics, 9th Ed., Pearson Prentice Hall. 6
• Risk Aversion & Indifference Curves
– Indifference curves that relate expected income to variability of income
(standard deviation) can be used to represent a person’s risk aversion
(Risk/Return Tradeoffs)
– Since risk is undesirable, greater risk requires greater expected income to
make the person equally well off
– Indifference curves are therefore upward sloping
U3
Expected U2
Income U1 Highly Risk Averse:
An increase in standard
deviation requires a large
increase in income to
maintain satisfaction

Standard Deviation of Income

Expected
Income Slightly Risk Averse:
A large increase in
U3
standard deviation
U2 requires only a small
increase in income to
U1 maintain satisfaction

Standard Deviation of Income

• Risk Neutrality and Indifference Curves

– A person who is risk neutral (only care about income; does not care about
risk) will have horizontal indifference curves in the return–risk tradeoffs

• Risk Loving and Indifference Curves

– A person who is risk loving (derives greater utility as risk increases) will
have downward sloping indifference curves in the return–risk tradeoffs

Source: Pindyck and Rubinfeld (2018), Microeconomics, 9th Ed., Pearson Prentice Hall. 7
Reducing Risk
• 3 ways to reduce risks: diversification, insurance, and obtaining more
information
• Diversification – allocating resources to a variety of activities whose outcomes
are not closely related (positively or negatively correlated)
– Investing in a portfolio of 10 or 20 different stocks
– Buying shares in mutual funds
 Organization that pools funds of individual investors to buy a large
number of different stock or other financial assets
• Insurance – paying a premium (= the expected loss from the risky situation) to
avoid risk
– A risk-averse individual counts losses (in terms of changes in utility) more
than gains
– The law of large numbers – although single events may be random and
largely unpredictable, the average outcome of many similar events can be
predicted
– Actuarial fairness – the insurance premium is equal to the expected payout
– Example: Burglary insurance: 100 people are similarly situated and face a
10-percent probability of a $10,000 loss
 Premium from the 100 individuals: $100,000
 Expected payout to the 100 individuals as a whole: $100,000

• Obtaining more information – if more information were available, a person

could make better predictions and reduce risk
– Value of complete information – difference between the expected value of a
choice when there is complete information and the expected value when
information is incomplete
– Example: There is a 0.5 probability that 100 suits will be sold and a 0.5
probability that 50 suits will be sold. How many suits to order if each suit
sells for $300 and any unsold suits can be returned for half of the price paid?
Profits from sales of suits:
Sales (unit of suits) Expected profit
With With
Buy
50 100 uncertainty complete
information
50 @$200 $5,000 $5,000 $5,000 $5,000
100 @$180 $1,500 $12,000 $6,750 $12,000

Source: Pindyck and Rubinfeld (2018), Microeconomics, 9th Ed., Pearson Prentice Hall. 8
 Value of complete information:
Expected value with complete information $8,500
Less: Expected value with uncertainty (buy 100 suits) 6,750
Value of complete information $1,750

The Demand for Risky Assets

• Even though most people are risk averse, they still invest all or part of their
savings in stocks, bonds, and other assets that carry some risk
– An asset – something that provides a flow of money or services to its owner,
e.g., an apartment building, a savings account, or shares of a company
 Capital gain (loss) – increase (decrease) in value of an asset
– Risky asset – asset that provides an uncertain flow of money or services to
its owner (e.g., stocks)
– Riskless (risk-free) asset – asset that provides a flow of money or services
that is known with certainty (e.g., Treasury bills)
– Nominal return – total money flow of an asset as a fraction of its price
– Real return – nominal return less the rate of inflation
– Expected return – return that an asset should earn on average
– Actual return – return that an asset earns
• The trade-off between risk and return
– The higher the expected return, the higher the risk
 Expected return from investing in the stock market, Rm > expected return
from investing in Treasury bills, Rf
– The investment portfolio
 Expected return on a 2-asset portfolio, Rp, with b (% of the portfolio)
invested in the stock market and (1 – b) invested in T-bills:
Rp = bRm + (1 – b)Rf
Rp = Rf + b(Rm – Rf )
 Standard deviation of the portfolio,p, is the % of the portfolio invested
in the stock market times the standard deviation of the stock market:
p = bm
• The investor’s choice problem:
– Risk and the budget line – describes the trade-off between risk (p) and
expected return (Rp)
(R  Rf )
Rp  R f  m p
m

Source: Pindyck and Rubinfeld (2018), Microeconomics, 9th Ed., Pearson Prentice Hall. 9
  Expected return on the portfolio, Rp, increases as the standard deviation
of that return p increases
 (Rm – Rf ) /m is the price of risk – extra risk that an investor must incur
to enjoy a higher expected return
– No risk – invest all the funds in T-bills (b = 0) and earn an expected
return Rf
– Incur a risk level of m – invest all the funds in stocks (b = 1) and earn
an expected return Rm
– Incur a risk level between 0 and m – invest some funds in each type of
asset and earn an expected return somewhere between Rf and Rm
Expected
return, Rp U3 U2 U1
Rm

R*

Rf

0 * m Standard deviation
of return, p

– Risk and indifference curves – describes combinations of risk and return that
leave the investor equally satisfied
 Upward-sloping because risk is undesirable
 With a greater amount or risk, it takes a greater expected return to make
the investor equally well-off
– The choices of different investors
 Investor A is highly risk averse – he invests mostly in risk-free asset
 Investor B is less risk averse – he invests mostly in stocks
 Investor C has very low degree of risk aversion – he invests more than
100% of his wealth in stocks (buy stocks on margin)

Source: Pindyck and Rubinfeld (2018), Microeconomics, 9th Ed., Pearson Prentice Hall. 10
 Expected UA UB UC
return, Rp

RC
Rm
RB

RA
Rf

0 A B m C Standard deviation
of return, p

Source: Pindyck and Rubinfeld (2018), Microeconomics, 9th Ed., Pearson Prentice Hall. 11