Uncertainty and Consumer

Behaviour

Chapter 5

Textbook: Microeconomics
By Robert Pindyck & Daniel Rubinfeld
Concepts
• Probability

• Expected Value

• Variance

• Standard Deviation Job 2 may be preferred over job 1

• Higher the variance / standard deviation - Higher

the risk
Flipping Coins
• Flip a fair coin:
• If heads - Win Rs. 10

• If tails - Rs. 0

• How much will you pay to play this game?

• Ticket price - x

• Expected value of earnings:

• 0.5(10 - x) + 0.5(0 - x)

• Play game if above is ≥ 0

• 5 - 0.5x - 0.5x ≥ 0

• 5≥x Max ticket price = Rs. 5

Flipping Coins
• Flip a fair coin:
• If heads - win Rs. 2
• If tails - play again
• If heads - win Rs. 4
• If tails - play again
• If heads - win Rs. 8 … and so on

• How much will you pay to play this game?

Flipping Coins

• Expected value:
(1/2)*2 + (1/4)*4 + (1/8)*8 + (1/16)*16 …

=1+1+1+…=∞

• Will you pay infinite sum of money to play this

game?

• St Petersburg Paradox
Offer
• A poor person finds a lottery ticket to will Rs. 100,000 with probability of
0.5 or nothing

• A rich passerby offers to give him Rs. 49,000 in exchange for the lottery
ticket.

• Should the poor person accept the offer?

• Is utility of Rs. 49,000 same as utility of expected Rs. 50,000?

• An individual should maximize expected utility and not expected value:

Bernouli
Risk Preference

E[u(x)] < U[E(x)]

E[u(x)] = U[E(x)] E[u(x)] > U[E(x)]

Risk Premium

An income of USD 20,000 with risk gives utility of 14

It is possible to get the same utility with USD 16,000 of certain income
The individual will be willing to pay a Risk Premium of USD 4000 to purchase certainty
USD 16,000 is called the certainty equivalent
Risk Premium and Indifference Curves

An increase in risk decreases utility. This has to be compensated by more income

Risk Assessment Tools

Portfolio Returns
• Risk free return: Rf; Market return: Rm

• Proportion of wealth invested in risky asset: b

• Proportion of wealth invested in risk free asset: (1-b)

• Portfolio return: Rp = bRm + (1-b)Rf

• Volatility of portfolio: 𝜎p = b𝜎m + (1-b)𝜎f = b𝜎m

• Rp can be written as: Rp = Rf + b(Rm – Rf) OR

• Rp = Rf + [(Rm – Rf)/ 𝜎m] 𝜎p

• The expected return on the portfolio (Rp) increases as the standard deviation of
the portfolio (𝜎p) increases

• Slope: (Rm-Rf)/ 𝜎m – extra risk the investor must bear to enjoy higher return
Choice Between Risk and Return

The slope of the Budget line gives the price of return in terms of risk: As expected
return on portfolio increases, there is an increase in risk
If all portfolio is invested in market – the maximum risk is 𝜎𝑚
Reducing Risk

• Diversification:
• Stock Markets and the mutual funds

• Insurance:
• Actuarial fairness: Expected premium = Expected payout
Problem
• A suits shop wants to place an order for suits for the next month.
If it places order for 50 suits, it has to pay USD 200 per suit. On
the other hand, if it places orders for 100 suits, it pays USD 180
per suit. The selling price in all cases is USD 300. If suits are
unsold, they can be returned for half the purchase price.
Sell 100 Suits Sell 50 Suits Expected Profit
Order 100 Suits 12000 1500 6750 Risk Taker
Order 50 Suits 5000 5000 5000 Risk Averse

• Probability of each scenario is 0.5

• How much would you pay for complete information on the quantity of
sales?
Problem
• Expected value of informed decision:
• If sales = 100 à Order 100 à Profit = 12000
• If sales = 50 à Order 50 à Profit = 5000
• Expected value = 8500

• Expected value with uncertainty (for risk neutral):

• Buy 100 à Sales = 100 à Profit = 12000
• Buy 100 à Sales = 50 à Profit = 1500
• Expected value à 6750

• Value of Information = 8500 - 6750 = 1750

Asset Returns

• Asset
• Risky assets
• Riskless assets

• Asset returns = return + capital gains

• Expected returns
• Actual returns

• Trade-off between risk and returns

Information Cascades
Behavioural Economics
Behavioural Economics
Consumer Decisions based on:

• Reference points: Real estate prices in Tier III cities seem cheap to someone who comes

from a metropolitan city

• Endowment Effect: Tendency of individuals to value an item more when one owns it.

• Mug experiment

• Loss Aversion: Negative Utility from loss greater than positive utility from gain of same

magnitude

• Framing

• Anchoring: Donate any sum: $20, $50, $100, Other

• Recency bias
Problem 1
Richard is deciding whether to buy a state lottery ticket.
Probability Return
Each ticket costs $1, and the probability of winning payoffs
0.5 $0
is given in the table. Richard’s utility function is U = W0.5
0.25 $1
• What is the expected value of Richard’s payoff if he buys 0.2 $2

a lottery ticket? What is the variance? 0.05 $ 7.50

• Richard’s nickname is “No-Risk Rick” because he is an

extremely risk-averse individual. Would he buy the
ticket?

• In the long run, given the price of the lottery tickets and
the probability/return table, what do you think the state
would do about the lottery?
Problem 2
You are an insurance agent who must write a policy for a new client named Sam. His company,
Society for Creative Alternatives to Mayonnaise (SCAM), is working on a low-fat, low-cholesterol
mayonnaise substitute for the sandwich-condiment industry. The sandwich industry will pay top
dollar to the first inventor to patent such a mayonnaise substitute. Sam’s SCAM seems like a very
risky proposition to you. You have calculated his possible returns table as follows:

• What is the expected return of Sam’s project?

• What is the most that Sam is willing to pay for insurance? Assume Sam is risk neutral.

• Suppose you found out that the Japanese are on the verge of introducing their own mayonnaise
substitute next month. Sam does not know this and has just turned down your final offer of
$1000 for the insurance. Assume that Sam tells you SCAM is only six months away from
perfecting its mayonnaise substitute and that you know what you know about the Japanese.
Would you raise or lower your policy premium on any subsequent proposal to Sam? Based on
his information, would Sam accept? Probability Returns
0.999 - 1,000,000
.001 1,000,000,000
Problem 3
Suppose that Natasha’s utility function is given by u(I) = √10I, where I represents
annual income in thousands of dollars

• Is Natasha risk loving, risk neutral, or risk averse? Explain.

• Suppose that Natasha is currently earning an income of $40,000 (I = 40) and can
earn that income next year with certainty. She is offered a chance to take a new
job that offers a 0.6 probability of earning $44,000 and a 0.4 probability of
earning $33,000. Should she take the new job?

• In (b), would Natasha be willing to buy insurance to protect against the variable
income associated with the new job? If so, how much would she be willing to
pay for that insurance? (Hint: What is the risk premium?)
Problem 4
A moderately risk-averse investor has 50 percent of her portfolio invested in stocks
and 50 percent in risk free Treasury bills. Show how each of the following events
will affect the investor’s budget line and the proportion of stocks in her portfolio:

• The standard deviation of the return on the stock market increases, but the
expected return on the stock market remains the same.

• The expected return on the stock market increases, but the standard deviation
of the stock market remains the same.

• The return on risk-free Treasury bills increases