Ambo University

College of Business and Economics

Department of Economics
Microeconomics I
•Chapter Two: Choice –involving Risk and Uncertainty
2.1. Introduction
2.2. Expected utility
2.3. Risk aversion
2.4. Diversification
2.5. Risk spreading
2.6. Asymmetric information
2.1. Introduction
 The traditional theory of demand examined so far implicitly
assumed a risk free world.

 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 with certainty, many of the choices that people
make involve considerable degree of uncertainty.
 Although risk and uncertainty are usually used interchangeably,
some people distinguish between the two.
Introduction …Cont’d
I. Uncertainty: refers to a situation when there are more than
one possible outcome to a decision-maker and where 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.
II. Risk: refers to a situation where there are more than one
possible outcomes to a decision-maker and the probability of
each specific outcome is known or can be estimated.
Certainty: refers to a situation where there is only one possible
outcome to a decision 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.
Introduction …Cont’d
 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.
1.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
Introduction …Cont’d

 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
2.2. Expected utility
 Expected Utility (EU): is the sum of the utilities associated with
all possible outcomes, weighted by the probability that each
outcomes will occurs.
 Suppose an individual has an income of Br.15, 000 and is
considering a new but risky sales job that will either double her
income to Br.30,000 or cause it to fall to Br.10,000.
 Each possibility has a probability of 0.5. The utility level associated
with an income Br.10,000 is 10 and the utility level associated with
an income of Br.30,000 is 18.
 The risky job must be compared with the current Br.15,000 job, for
which the utility level is 13.
 To evaluate the new job, individual can calculate the value of the
resulting income.
Expected utility … Cont’d
 Because we are measuring value in terms of the consumer‟s
utility, we must calculate the expected utility E(u) that the
individual can obtain then.
 E(u) = (1/2) u (Br.10,000) + (1/2) u (Br. 30,000)
= 0.5(10) + 0.5(18) = 14.
 The new risky job is thus preferred to the original job because
the expected utility of 14 is greater than the original utility of
13.
 One particular convenient form that the utility function might
take is the following u(c1 , c2 , 1 ,  2 )  1 (c1 )   2 (c2 )
 So, utility function is referred with particular form described
as expected utility function, or, sometimes, a Von
Neumann-Morgenstern utility function.
Expected utility … Cont’d
 In decision theory, the von Neumann–Morgenstern utility
theorem demonstrates that rational
choice under uncertainty involves making decisions that take
the form of maximizing the expected value of some cardinal
utility function.
 This function is known as the von Neumann–Morgenstern
utility function which was named after a Hungarian born
American mathematician and physicist John von Neumann
and German-born economist Oskar Morgenstern.
 The theorem forms the foundation of expected utility theory.
Expected utility … Cont’d
 The expected utility function satisfies the condition that the
marginal rate of substitution between the two goods is
independent of how much there is of the 3rd good.
U (c1 , c2 , c3 ) / c1
MRS12 
U (c1 , c2 , c3 ) / c2
 1u (c1 ) / c1
MRS12 
 2 u ( c 2 ) /  c 2

 This Marginal Rate of Substitution depends only on how

much you have of goods 1 and 2, not how much you have of
good 3.
Expected utility … Cont’d

1. Variability: is the extent to which the possible outcomes of

    
n n
   X  x   X i E( X )
2 2
2
an uncertain event differ.Variance
i 1 i i 1

2.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.Variance    Pi   
n
X i E( X i )
2 2

i 1

SD      Pi  X i  E ( X i ) 
n 2
2
i 1

Where Pi is probability of an outcome

Preferences Toward Risk
 Risk preference is defined as how much risk a person is
willing to take based on the expected utility, or satisfaction, of
the outcome.
 The three risk preference types are risk-averse, risk-neutral,
and risk-loving.
Risk averse: Condition of preferring a certain income to a
risky income with the same expected value.
Risk neutral: Condition of being indifferent between a
certain income and an uncertain income with the same
expected value.
Risk loving: Condition of preferring a risky income to a
certain income with the same expected value.
Preferences Toward Risk

The Risk Attitude Spectrum

Preferences Toward Risk : Risk aversion
 Risk aversion is the tendency to avoid risk and to have a low
risk tolerance.
 Risk-averse investors prioritize the safety of principal over the
possibility of a higher return on their money. Thus, 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 (MUI) diminishes as income rises.
Preferences Toward Risk : Risk aversion
 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 – A1).
 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 figure below makes this point more clear.
Preferences Toward Risk : Risk aversion
 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 figure below makes this point more clear.
Preferences Toward Risk : Risk aversion
 From the 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.
Preferences Toward Risk : Risk aversion

 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.
Preferences Toward Risk : Risk Neutral
 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.
Preferences Toward Risk : Risk Neutral

 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.
Preferences Toward Risk : Risk Loving
 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.
Preferences Toward Risk : Risk Loving
Preferences Toward Risk : Risk Loving
 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) = 0.5 U(10 Birr) + 0.5 U(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 be compensated by a higher expected value of
income so as to a leave a person on the same level of utility.
 Reducing Risk: Diversification

 In the face of a broad variety of risky situations, people are

generally risk averse.

 Consumers and managers commonly reduce risk using various

ways. The major ones are: diversification, insurance and
obtaining more information.

 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.”
Reducing Risk: Diversification
 Suppose shares of the raincoat company and the sunglasses
company currently sell for Br.10 a piece.
 If it is a rainy summer, the raincoat company will be worth
Br.20 and the sunglasses company will be worth Br.5.
 If it is a sunny summer, the payoffs are reversed: the
sunglasses company will be worth Br.20 and the rain coat
company will be worth Br.5.
 If he invests his entire Br.100 in the sunglasses company, he is
taking a gamble that has a 50% chance of giving you Br.200
and a 50% chance of Br.50.
 The same magnitude of payoffs results if he invests all his
money in the sunglasses company: in either case he has an
expected payoff of Br.125 i.e. 0.5*100+0.2*50=125
Reducing Risk: Diversification
 But what happens if he put half of his money in each. Then if
it is sunny he get Br.100 from the sunglasses investment and
Br.25 from the rain coat investment.
 But if it is rainy, you get Br.100 from the raincoat investment
and Br.25 from the sunglasses investment.
 Either way, you end up with Br.125 for sure.
 By diversifying his investment in the two companies he has
managed to reduce the overall risk of his investment, while
keeping the expected payoff the same.
Reducing Risk: Insurance

 Insurance: an arrangement by which a company/state

undertakes to provide a guarantee of compensation for
specified loss, damage, illness, or death in return for payment
of a specified premium
 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
Reducing Risk: The Value of Information
 The value of 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.
Risk Spreading

 Risk spreading: is spreading once own risk taking intentions

to a variety of activities to minimize the risk related losses.
 Consider a situation of an individual who had Br 35,000 and
faced a 0.1 probability of a Br10,000 loss.
 Suppose that there were 1,000 such individuals.
 Then on average, there would be 10 losses incurred, and
thus Br.100,000 lost each year.
 Each of the 1,000 people would face an expected loss of 0.1
times Br.10,000.
 Suppose the probability that any person incurs a loss does
not affect the probability, that any of the others incur losses.
That is, let us suppose that the risks are independent.
Risk Spreading

 Suppose each individual decides to diversify the risk that he

or she faces. How can they do this?
 Answer: by selling some of their risk to other individuals.
 Suppose that the 1000 individuals decide to insure one
another.
 If anybody incurs the Br.10,000 loss, each of the 100
individuals will contribute Br.10 to the loss facing individual.
This way, an individual‟s house burns down is compensated
for his loss, and the other individuals have the safety cover,
that they will be compensated, if they happened to face the
similar disaster.
 This is an example of risk spreading, in which each individual
spread his risk over all of the other individuals and thereby
reduces the amount of risk he bears.
An Overview on an asymmetric information
 Economists use the term asymmetric information to describe
situations in which buyers and sellers are not equally well
informed about the characteristics of product or services.
 In these situations, sellers are typically much better informed
than buyers, but sometimes the reverses will be true.
 Asymmetric information refers to when one party in a
transaction posseses more information than the other.
Asymmetric information
 This asymmetric information affects the behavior of market
participants and explains a wide variety of phenomenon in
modern economy lead to opportunistic behaviors which in turn
lead to market failure, destroying many desirable properties of
competitive markets. Example: Market for used car –Lemons
vs new car
 When both parties to a contract (transaction) have no equally
information, transaction is not efficient as information
advantage leads to problems of opportunism, where by the
informed party or person benefit at the expense of the person
with less information.
 The opportunistic behavior or asymmetric information creates
two problems namely Moral Hazard and Adverse selection.
Asymmetric information : Moral hazard problem

 The moral hazard problem occurs when one party to a

contract engages in opportunistic behavior after the contract
is made.
 A Moral hazard problem exists when one of the parties to
contract has an incentive to alter his or her behavior after the
contract is made at the expenses of the second party to get
benefit.
 It arises as it is too costly for the second party to obtain
information about the first party‟s post contractual behavior
and hidden action. Stating differently it is opportunism
characterized by an informed person‟s taking advantage of a
less informed person through an unobserved action.
Asymmetric information : Moral hazard problem

 Example: An insured people find to take unobserved action

(engage in risky behavior or take lesser precaution) that
increase the probability of large claims against insurance
companies. Individual is will spend less on preventive health
care and thus the probability or getting in to risk rises
Asymmetric information : Adverse Selection
 The adverse selection is other problem which arises prior to
the making of the contract transactions between parties.
 It is the tendency for people to enter in to agreements in
which they can use their private information to their own
advantage and to the disadvantage of the less informed party.
 It occurs as the cost of obtaining the relevant information
makes it difficult to determine whether the real is a good one
or a bad one.
 Suppose there are many producer of umbrella in which some
produce high - quality product at with PH prices and the
others produces low- quality product at PL.
 If the market is competitive, it has an incentive to produce
only low–quality umbrellas as each producer has negligible
effect on others.
Asymmetric information : Adverse Selection
 The Low–quality umbrella production has destroyed the
market, for both qualities of good.
 That is, low quality item crowded out high quality items
because of the high cost of acquiring information.
Asymmetric information : Solutions
 There are two main methods of solving adverse
selection and moral hazard. These are:
1. Restrictions opportunistic behavior or controlling opportunistic
behavior:
- In the first case the government or the concerned body
restrict this behavior by law or use different mechanisms
such as standardization, certifications…etc.
Asymmetric information : Solutions
2. Equalizing information
 In relation to the second either informed or uniformed parties
can eliminate information problems through
 Screening is an action taken by a uniformed person to
determine the information possessed by informed people. A
buyer may test – drive (screen) several used cars to determine
which one starts and handles the best
 Signaling is an action taken by an informed person to send
information to a less informed persons.