AF5041 Intermediate Microeconomics

Lecturer: Dr. Matthew Shannon

Email: Matthew.Shannon@northumbria.ac.uk

Office Hours: By Appointment (email me!)

Course Overview (my part)
▪ Week 6 – Uncertainty
▪ Perloff 5th edition – Chapter 16 (section 16.1 – 16.4)

▪ Week 7 – Behavioural Economics

▪ Perloff 5th edition – Chapter 16 (section 16.5)
Today – Uncertainty

1. Assessing Risk
▪ Keywords: defining risk; probability distributions; expected value

2. Attitudes Towards Risk

▪ Keywords: risk averse/neutral/preferring; expected utility; Arrow-Pratt measure of risk
aversion

3. Reducing Risk
▪ Keywords: diversification
1. Assessing Risk
Assessing Risk

▪ Risk exists when (1) the likelihood of each possible outcome is

known, and (2) no single outcome is certain to occur.

▪ Probability is a number between 0 and 1 that indicates the

likelihood that a particular outcome will occur.
Assessing Risk
We estimate probability (θ) with frequency, the number of times
that one particular outcome occurred (n) out of the total number
of times an event occurred (N).
n
=
N
Example:
▪ N, the total number of times a die is rolled
▪ n, the number of times the die rolls a six
Assessing Risk
A probability distribution relates the probability of occurrence to
each possible outcome.
Assessing Risk
▪ Expected value = the value of each possible outcome (Vi) times the
probability of that outcome (θ i), summed over all n possible outcomes:
n
EV =  iVi
i =1

Use EV to find the Variance (a measure of risk)

▪ Variance measures the spread of the probability distribution (i.e. how
much variation there is between the actual value and the expected value):
n
Variance =  i (Vi − EV )2
i =1

▪ Standard deviation (σ) is the square root of the variance and is a more
commonly reported measure of risk.
 Assessing Risk – Example
Example: Greg schedules an outdoor event
▪ If it doesn’t rain, he’ll make $15 in profit
▪ If it does rain, he’ll make −$5 in profit (loss)
▪ There is a 50% chance of rain
Find the (i) Expected Value; (ii) Variance; (iii) Standard Deviation of this outdoor event
 Assessing Risk – Example (cont.)
Example: Greg schedules an outdoor event
▪ If it doesn’t rain, he’ll make $15 in profit
▪ If it does rain, he’ll make −$5 in profit (loss)
▪ There is a 50% chance of rain
Find the (i) Expected Value; (ii) Variance; (iii) Standard Deviation of this outdoor event

Greg’s expected value (outdoor event):

EV = Pr (no rain)  Value(no rain) + Pr (rain)  Value(rain)

1  1 
=   $15  +   ( −$5) = $5
2  2 
 Assessing Risk – Example (cont.)
Example: Greg schedules an outdoor event
▪ If it doesn’t rain, he’ll make $15 in profit
▪ If it does rain, he’ll make −$5 in profit (loss)
▪ There is a 50% chance of rain
Find the (i) Expected Value; (ii) Variance; (iii) Standard Deviation of this outdoor event

The variance (of the outdoor event):

2 = 1  (V1 − EV )2  + 2  (V2 − EV )2 
1 2 1 2
=   ($15 − $5)  +   ( −$5 − $5) 
2  2 
1  1 
=   ($10)2  +   ( −$10)2  = $100.
2  2 
 Assessing Risk – Example (cont.)
Example: Greg schedules an outdoor event
▪ If it doesn’t rain, he’ll make $15 in profit
▪ If it does rain, he’ll make −$5 in profit (loss)
▪ There is a 50% chance of rain
Find the (i) Expected Value; (ii) Variance; (iii) Standard Deviation of this outdoor event

The standard deviation (of the outdoor event):

Standard Deviation (𝞼)
𝜎 = 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒

𝜎 = 100
𝜎 = $10
 Assessing Risk – Example 1 (cont.)
Example, continued: Greg schedules an indoor event
▪ If it doesn’t rain, he’ll make $10 in profit
▪ If it does rain, he’ll make $0 in profit
▪ There is still a 50% chance of rain.

Get into groups or two or more…

Find the (i) Expected Value; (ii) Variance; (iii) Standard Deviation of this indoor event

Which event is less risky (the outdoor or indoor event)? Why?

2. Attitudes Towards Risk
Attitudes Towards Risk
Although indoor and outdoor events have the same expected value,
the outdoor event involves more risk.
▪ He’ll schedule the event outdoors only if he likes to gamble.

A fair bet is a wager with an expected value of zero.

▪ We classify people according to their attitudes toward risk:

▪ Risk Averse: someone who is unwilling to make a fair bet.
▪ Risk Neutral: someone who is indifferent about a fair bet.
▪ Risk Preferring: someone who is willing to make a fair bet.
Attitudes Towards Risk
▪ We classify people according to their attitudes toward risk:
▪ Risk Averse: someone who is unwilling to make a fair bet
▪ Risk Neutral: someone who is indifferent about a fair bet
▪ Risk Preferring: someone who is willing to make a fair bet.

Question:
▪ Look back on the indoor vs outdoor event example
▪ Which event would a risk averse/neutral/preferring person choose? Give
reasons for your answer.
Expected Utility Theory
We can include risk in a model of utility maximization by assuming people
maximize expected utility.

Expected utility, EU, is the probability-weighted average of the

utility, U ( g) , from each possible outcome:
n
EU =  iU (Vi )
i =1

▪ Note: A person whose utility function is concave picks the less-risky choice if
both choices have the same expected value.
Expected Utility Theory – Example 2

Suppose Bob has the following Utility function for money (V):

U = 2(V)0.5

Question: What is Bob’s Expected Utility from the following fair coin toss
game where…
▪ Heads, wins $10
▪ Tails, losses $5
 Attitudes Towards Risk
Example: Risk-averse Irma and wealth
– Irma has initial wealth of $40
– Option 1: keep the $40 and do nothing → U($40) = 120
◼Expected value of wealth is $40

– Option 2: buy a vase that she thinks is a genuine Ming vase with probability of 50%
◼If she is correct, wealth = $70 → U($70) = 140
◼If she is wrong, wealth = $10 → U($10) = 70

◼Expected value of wealth remains $40 = 1Τ2 . $70 + 1Τ2 . $10

◼Expected value of utility is 105 = 1Τ2 . 140 + 1Τ2 . $70
 Attitudes Towards Risk
Example: Risk-averse Irma and wealth
– Irma has initial wealth of $40
– Option 1: keep the $40 and do nothing → U($40) = 120
◼Expected value of wealth is $40

– Option 2: buy a vase that she thinks is a genuine Ming vase with probability of 50%
◼If she is correct, wealth = $70 → U($70) = 140
◼If she is wrong, wealth = $10 → U($10) = 70

◼Expected value of wealth remains $40 = 1Τ2 . $70 + 1Τ2 . $10

◼Expected value of utility is 105 = 1Τ2 . 140 + 1Τ2 . $70

Key Takeaway: Although both options have the same expected value of wealth, the
option with risk has lower expected utility.
Risk Aversion
▪ Irma is risk-
averse and
would pay a risk
premium to
avoid risk.
Degree of Risk Aversion
One common measure of risk aversion is the Arrow-Pratt measure of
absolute risk aversion:
d2U (W ) / dW 2
(W ) = −
dU (W ) / dW

𝜌 𝑊 > 0 , for risk-averse people

𝜌 𝑊 = 0 , for risk-neutral people
𝜌 𝑊 < 0 , for risk-preferring people

▪ The larger the Arrow-Pratt measure, the smaller the gambles that an
individual is willing to take.
Degree of Risk Aversion – Example
Derive the Arrow-Pratt measure of absolute risk aversion for the following utility
functions. Which represents the greatest level of risk aversion according to the
measure?
a. 𝑈 𝑋 = 2𝑋 3 + 4
1
b. 𝑈 𝑋 =1−
𝑋
Reducing Risk
1. Obtain Information
▪ Additional relevant information reduces the probability of
choosing a ‘bad’ outcome.

2. Insurance

3. Diversification
▪ “Don’t put all your eggs in one basket.”
Avoiding Risk Via Diversification
Risk Pooling / Diversifying:
▪ I can reduce my overall risk by making many risky investments instead of
just one.
▪ Diversification eliminates all risk if two events are perfectly
negatively correlated (correlation = -1)
▪ Diversification does not reduce risk if two events are perfectly
positively correlated (correlation = +1)

Note: Diversification can reduce risk even if two events are somewhat
positively correlated (i.e. as long as correlation < +1)
▪ Example: investors reduce risk by buying shares in a mutual fund,
which is comprised of shares of many companies.
Avoiding Risk Via Diversification – Example
▪ Firm A and Firm B compete for a government contract.
▪ Each firm has a 50% chance of winning the contract
▪ Before the awarding of the contract, you can buy stock in either company for
$20.
▪ The contract winning Firm’s stock will increase to $40
▪ The contract losing Firm’s stock will decrease to $10

Questions:
1. If you buy two shares in one of the companies, what is the expected value of this
investment? And the variance?
2. If you buy one share in each firm, what is the expected value of this investment?
And the variance?
3. Which investment option will a risk-averse person choose and why?
Next week
▪ In the standard utility model, we assume people make rational choices
▪ Not always true. People can be systematically biased.
▪ Next Week – Behavioural Economics
▪ Appling psychological insights into human behaviour to explain economic
decision-making.

https://irrationallabs.c
om/blog/what-is-
behavioral-
economics/