CHAPTER TWO

CHOICE INVOLVING RISK AND UNCERTAINTY

2.1. Introduction
The traditional theory of demand examined so far implicitly assumed a risk free
world. Information on prices and income is known by the consumer (decision maker).
But many of the choice problems that the consumers face entail uncertainty about the
possible outcomes of income, price and other variables. It assumed that consumers
face complete certainty as to the results of the choices they make. Clearly, this is not
the case in most instances. In contrary to our earlier assumptions of price, income
and other variables to be known (in chapter one) with certainty, many of the choices
that people make involve considerable degree of uncertainty. Information is a key
input in decision making. Decision made under uncertainty of information involves
some kind of risk. Although risk and uncertainty are usually used interchangeably,
some people distinguish between the following:
Ü Uncertainty: refers to a situation when there is more than one possible
outcome to a decision-maker and the probability of each specific outcome is not
known. This may be due to insufficient past information or instability in the
structure of the variables.
Ü Risk: refers to a situation when there is more than one possible outcome to a
decision-maker and the probability of each specific outcome is known or it can
be estimated.
Ü Certainty: refers to a situation where there is only one possible outcome to a
decision maker and this outcome is known precisely. For example, investing on
treasury bills leads to only one outcome (i.e. the amount of the yield), and this
is known with certainty.
2.2. Probabilities
Even though you do not know what the value of uncertain investment (for example
investment in stock) will be next year, you can still describe what it might be. In
particular, suppose you know that over the next year, one of three things will happen
to your $100 investment:
Its value could go up by 20 percent to $120 (outcome A).
Its value could remain the same (outcome B).
Its value could fall by 20 percent to $80 (outcome C).

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For any lottery, the probabilities of the possible outcomes have two important
properties:
1) The probability of any particular outcome is between 0 and 1.
2) The sum of the probabilities of all possible outcomes is equal to 1.
Utility Function under Uncertainty
If the consumer has reasonable preferences about consumption in different
circumstances, a utility function can be used to describe these preferences. However,
under conditions of uncertainty some additional structure, called probability, needs to
be added to the choice problem.
2.3. Expected Value and Variation of Risky Choices
We usually need two measures to describe and compare risky choices. These
measures are expected value and variation.
a) Expected value: is the weighted average of all possible payoffs/outcomes that
can result from a decision under the various states of nature, with the
probability of those payoffs used as weights. It measures the value that we
would expect on average.
If we multiply each possible outcome or payoff by its probability of occurrence and
add up these products, we get the expected value. If, for instance, there are two
possible outcomes having payoffs X1 and X2 and if the probability of each outcome is
given by P1 and P2, then the expected value is:
E(X) = P1X1 + P2X2
Example: If the probability that an oil exploration project will be successful is ¼ and
the probability that it will be unsuccessful is ¾, and if success yields a payoff of 40
Birr per share while failure yields a payoff of 20 Birr per share, the expected value is:
E(X) = P(success)(yield from success) + P(failure)(yield from failure)
¼ (40 Birr/share) + ¾ (20 Birr/share)
(10 + 15) Birr/share
25 Birr/share
b) Variability: is the extent to which the possible outcomes of an uncertain event
may differ from their expected value. We use variance or standard deviation to
see the variation of individual outcomes from their expected value. We measure
variability by recognizing that large differences between the actual and expected
value imply the greater risk.

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 +…+

Suppose you are choosing between two part time sales jobs that have the same
expected income of 1500 birr:
 The first job is based entirely on commission; i.e., the income earned depends on
how much you sell. There are two equally likely payoffs for this job: 2000 birr for a
successful sales effort and1000 birr for one that is less successful.
 The second job is salaried. It is very likely (0.99 probabilities) that you will earn
1510 birr, but there is 0.01 probability that the company will go out of business, in
which case you would earn 510 birr in separation pay.
Note that these two jobs have the same expected income:

For job 1: Expected Income

For job 2: Expected Income

However, the variability of the two job offers is different. We measure variability by
recognizing that large differences between actual and expected payoffs (whether positive
or negative) imply greater risk.
The variability for the two jobs can be calculated by the using the formula for
variance:

We can also measure variability by using the standard deviation (SD) formula. SD is the
square root of variance:

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 Thus, job 1 entails higher risk because the variability associated with its payoffs
are greater than job 2 (i.e., 500 > 99.5). However, this does not mean that rational
decision makers will choose job 1 to job 2. The choice of alternatives with different
risk levels depends on the attitudes or preferences that individuals have towards risk.
Standard deviation is the often used measure of variability. Standard deviation
measures the dispersion of the possible outcomes from the expected value. The
smaller the value of the standard deviation (σ), the tighter or less dispersed the
distribution is and thus the lower would be the risk attached to it, and vice versa. If
the two alternatives have the same expected value, the one with the lower/smaller
standard deviation is less risky and is hence the preferred one. If, however, one
alternative offers a higher expected value but is much riskier than the other one and
vice versa, the preference depends on the individual whether he/she is a risk averse,
a risk neutral, or a risk loving person.
2.4. Individual’s Preferences Towards Risk
A Risk Averse Person: is a person preferring a certain income to a risky income
with the same expected value. For a risk averse person, losses are more important (in
terms of the change in utility) than gains. Losses hurt him/her more seriously than
gains benefit him/her. Thus, the marginal utility of income (MU I) diminishes as
income rises.
To illustrate, assume that a person can either have a certain income of 20 Birr, or
an alternative decision yielding an income of 30 Birr with probability of 0.5 and an
income of 10 Birr with probability 0.5. The expected income from this second
alternative (A2) is: E(A2) = 0.5(30) + 0.5(10) = (15 + 5) Birr = 20 Birr. This is the
same as the income earned without risk (from the first alternative – A 1). A risk
averse person facing this situation prefers to consume the risk free 20 Birr to
trying the alternative in which he/she could have consumed 30 Birr if successful or
10 Birr if unsuccessful. The figure2.1 below makes this point more clear.

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 Figure 2.1: Utility Function for a Risk Averse Individual
From this figure, we see that utility at point B is greater than utility at point C. The
utility of this risk averse person from the risk free income of 20 Birr is 16 (point B)
and the expected utility from the risky alternative is:
E(U) = 0.5U(10 Birr) + 0.5U(30 Birr)
0.5(10) + 0.5(18)
14 (point C).
Note that the expected utility, E(U), is the sum of the utilities associated with all
possible outcomes weighted by the probability that each outcome will occur. The risk
averse person achieves the expected utility of 14 at a lower, but a risk free, income of
16 Birr. That is, a risk free income of 16 Birr gives the same level of satisfaction as a
risky alternative with an expected income of 20 Birr. Thus, he/she is willing to pay or
forgo 4 Birr (20 Birr – 16 Birr = 4 Birr) to avoid taking risk. The maximum amount of
money (4 Birr in our case) that a risk averse person will pay to avoid taking a risk is
called a risk premium.
Behaviors of a Risk Averse Individual
1. Risk averse individuals do not like risks. They do not like uncertainties that
surround the risk no matter how big the payoff could be.
2. Risk averse people are often investors those who are looking to make the best
investment. This often means a possible lower payoff with known risks in order to
avoid higher or unknown risks.
3. Even though some investments result in higher payoffs, such as those in the stock
market, a risk averse investor would rather get a definite return, such as investing
in government bonds.

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A Risk Neutral Person: is a person who is indifferent between a certain income and
an uncertain income with the same expected value. For this person, the marginal
utility of income is constant.

The utility of this risk neutral person from the risk free income of 20 Birr is 12 (point
C) and the expected utility from the risky alternative is:
E(U) = 0.5U(10 Birr) + 0.5U(30 Birr)
0.5(6) + 0.5(18)
12 (the same point C).
As 12 = 12, the risk neutral person is indifferent between the risky and the risk
free alternatives.
A Risk Loving Person: is a person who prefers a risky income to a certain income
given that the risky alternative has the same expected value as the certain income.
This person may prefer an uncertain income to a certain one even if the expected
value of the uncertain income is less than that of the certain income. The expected
utility of the uncertain income is greater than the utility of a certain income for a
risk loving person and thus their utility of income curve is upward bending.

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The utility of this risk loving person from the risk free income of 20 Birr is 8 (point B)
and the expected utility from the risky alternative is:
E(U) = 0.5U(10 Birr) + 0.5U(30 Birr)
0.5(3) + 0.5(18)
10.5 (point C).
As 10.5 > 8, the risk loving person prefers
the risky alternative to the risk free alternative.
Risk loving people prefer alternatives with high expected value and high standard
deviation (risk) to a lower paying but less risky alternative (unlike the risk averse
people). However, risk loving people are few at least with respect to major
purchases or large amounts of income or wealth.
Risk Aversion and Indifference Curves
We also describe the extent of a person’s risk aversion in terms of indifference
curves that relate the expected income to the variability of income, the latter
being measured by the standard deviation. An indifference curve shows the
combinations of the expected value and the standard deviation of income that give
the individual the same level/amount of utility. Indifference curves are upward
sloping. This is because risk is undesirable (a ‘bad’) so that the greater the amount
of risk, the greater the amount of income needed to make the individual equally
well-off. An increase in the standard deviation (a higher variability of income) must

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be compensated by a higher expected value of income so as to a leave a person on
the same level of utility.
As opposed to the case of a highly risk avert person, a slightly risk avert person
requires only a small increase in expected income, E(I) for a large increase in the
standard deviation of income (σ).

E(I) U3 E (I)
U2

U1
U3
U2
U1

O σ O σ
Panel (a): Indifference curves of Person A Panel (b): Indifference curves of Person B
Figure 2.4: Person A is more Risk Averse than Person B

Risk Premium
The risk premium is the amount of money that a risk-averse person would pay to
avoid taking a risk.
What is premium?
People face risks every time they take a shower, walk across the street, or make an
investment. However, there are financial institutions such as insurance markets and
the stock market that can mitigate at least some of these risks. Individuals have
certain behavior with respect to choices involving uncertain. For instance, consumer
is mostly concerned with the probability distribution of getting different consumption
bundles of goods, which consists of list of different outcomes-consumption bundles
and probability associated with each outcome. When a consumer decides how much
automobile insurance to buy or how much to invest in the stock market, he is thus
deciding on a pattern of probability distribution across different amounts of
consumption.

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For example, suppose that you have $100 now and that you are thinking of buying
lottery ticket number 13. If number 13 is drawn in the lottery, the holder will be paid
$200. This ticket costs, say, $5. The two outcomes that are of interest are the event
that the ticket is drawn and the event that it is not. Your original endowment of
wealth-the amount that you would have if you did not purchase the lottery ticket-is $
100 if 13 is drawn, and $100 if it isn't drawn. However, if you buy the lottery ticket
for $5, you will have a wealth distribution consisting of $295 if the ticket is a winner,
and $95if it is not a winner. The original endowment of probabilities of wealth in
different circumstances has been changed by the purchase of the lottery ticket. The
same principles apply to gambles over goods, but in this case we restrict gambles to
monetary outcomes to make it simple.

2.5 Minimizing/Reducing Risk

In the face of a broad variety of risky situations, people are generally risk averse.
Consumers and managers commonly reduce risk using four ways. The major ones
are diversification, insurance and obtaining more information, and Risk Spreading.
1. Obtaining more information: People often make decisions based on limited
information. If more information were available, one could make better predictions
and reduce risk. Even though forecasting is inevitably imperfect, it may be worth
investing in a marketing study that provides a reasonable forecast for the future.
2. Risk Spreading: In the absence of formal insurance, a group of individuals can
agree to share a loss incurred by each individual from their group.
3. Diversification: refers to reducing risk by allocating resources to a variety of
activities whose outcomes are not closely related –“Don’t put all your eggs in one
basket. ”Given that a consumer is a risk averse, he/she minimizes the risks of
uncertainty by diversifying his holding or assets.
4. Purchase of Insurance: If the cost of insurance is equal to the expected loss, risk
averse people will buy enough insurance to recover fully from any losses they
might suffer. For a risk averse consumer, the guarantee of the same income
regardless of the actual outcome generates more utility than would be the case if
that person had a high income when there was no loss and a low income when a
loss occurred.
Let us imagine that you are risk averse and you have just purchased a new car. You
can minimize the risk by buying the insurance for your car. Because a risk-averse
decision maker prefers a sure thing to a lottery with the same expected value, you
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will prefer to buy a fair insurance policy that provides full coverage against a loss
rather than buy no insurance at all.
Questions
Based on the following information, answer the questions 1, 2 and 3! Suppose a man
currently has 38,000 birr and he is considering taking a new but risky job that will
increases his wealth to 50,000 birr with likelihood of 0.6 if it succeeds but will reduce
his wealth to 20,000 birr with probability of 0.4 if it fails. The utility level associated
with 38,000 birr is 20, the utility level associated with an income of 20,000 birr, and
50,000 birr is 15 and 30, respectively.
1. What is the expected utility of the new job? ________.
2. What will be the type of person in taking risk? ______.
3. Expected income of the new job is ____.

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