Chapter II: Consumption Choice

Involving Risk
• Chapter Outline
• Introduction
• Expected Income or Wealth
• Expected Utility
• Measuring Risk
• Attitudes toward Risk
• Risk aversion
• Risk lovers
• Risk reduction mechanisms
• Diversification, insurance and information

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 2.1. Introduction/Motivation/
• So far we have assumed that prices, incomes, and
other variables are known with certainty…no risk.
• Actually, many of the choices that people make
involve considerable uncertainty.
• Uncertainty is a fact of life. People face risks
every time they take a shower, walk across the
street, or make an investment.
• Example
– Borrowing to finance consumption, to pay tuition
– Future income can not be known with certainty
– Price of goods may rise beyond expectation

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• The question is:
– how should we take these uncertainties into
account when making major consumption or
investment decisions?
• Since income of the consumer is not known
for sure, we will use expected income as
determinant of consumption
• Similarly, since there are a number of factors
that might affect the occurrence of an events,
it is better to study about expected utility.

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 Risk and uncertainty
• Risk and uncertainty: are they the same?
– Uncertainty can refer to situations in which many outcomes are possible but their likelihoods
are unknown.
– Risk refers to situations in which we can list all possible outcomes, and we know the likelihood
that each outcome will occur.
– In this course, we simplify the discussion by using uncertainty and risk interchangeably.
• Sometimes we must choose how much risk to bear.
• What, for example, should you do with your savings?
– Should you invest your money in something safe ,such as a savings account,
or something riskier but potentially more lucrative, such as the stock market?
• Another example is the choice of a job or even a career.
– Is it better to work for a large, stable company where job security is good
but the chances for advancement are limited, or to join (or form) a new
venture, which offers less job security but more opportunity for
advancement?
• To answer questions such as these, we must be able to quantify risk so we can
compare the riskiness of alternative choices.

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Describing Risk…..the probability

• To describe risk quantitatively, we need to

know all the possible outcomes of a particular
action and the likelihood that each outcome
will occur
– This takes us to the probability theory
• Probability refers to the likelihood that an
outcome will occur.
number of possible outcomes of an event at a time
p(H) 
Total number of events

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 Examples of probabilities
• Tossing a coin…….(fair gamble)
– P(head)=P(h)=0.5
– P(tail) =P(t)=0.5 or P(t) =1- P(h)
• Tossing a die
– P(odd)=3/6=0.5

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 Expected Income or Wealth
• Payoff- the result of set of actions.
• Expected income or wealth refers to a weighted average of payoffs
resulting from all possible outcomes
– The weights are the probability that each outcome will occur
• The expected value measures the central tendency, that is, the
average payoff.
• Eg1: Suppose that with your original endowment of wealth of Birr
500, you want to buy a lottery of Birr 20 with a prize money of Birr
10,000
• The two possible payoffs
– 480 + 10,000 = Birr 10,480 …..If she wins
– 500 - 20 =Birr 480,…..if she loses
• Need of Contingent consumption plan
– It is a specification of what will be consumed in each different state of
nature

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 Expected Income=E(Y)
• If the probability that she wins is 0.5, the
expected income ,E(Y) will be
E (Y )  0.5(10 , 480 )  0.5( 480 )
E (Y )  5240  240
E (Y )  5480

• If we have n number of possible outcomes (V)

with possible probabilities of p1, p2, ….pn,
E (Y )  p1V1  p2V2  ....  pnVn

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 Utility functions and Probability
….The Expected Utility =E(U)
• Utility under certainty depends on goods
consumed
• Under uncertainty, how a person values
consumption in one state as compared to
another depends on the probability that the
event in question will actually occur.
• Hence, the utility function depends on the
probabilities as well as on the consumption
levels
• U = U(consumption, probabilities)
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• If the consumption of good 1 is C1 with probability P1
and consumption of good 2 is C2 with probability P2,
then expected utility can be expressed as:
• U = U(C1,C2,P1,P2)
• If the two events are mutually exclusive,P2 = 1-P1
• Examples of expected utility functions
– E(U) = U(C1,C2,P1,P2)= P1C1+C2P2…….Perfect substitutes (U=aX+bY)
– E(U) = U(C1,C2,P1,P2)= C1P1 C2 P2…… Cobb-Douglas Utility fun
• lnU(C1,C2,P1,P2)= P1lnC1+P2lnC2
• This says that utility can be written as a weighted sum
of some functions of consumption in each state, v(c1)
and v(c2)…the weights are the probabilities
• von Neumann-Morgenstern Utility function
– U(C1,C2,P1,P2)= P1v(C1)+P2v(C2)

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• If one of the states is certain, so that P1=1, then
v(c1) is the utility of a certain consumption in
state 1.
• If P2=1, v(c2) is the utility of consumption in state 2
• Thus, P1v(C1)+P2v(C2) represents the average utility,
or the expected utility, of the pattern of
consumption(C1, C2)
• Preferences over certain choices will have the
structure implied by this function
• Why?........the independence assumption

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 PREFERENCES TOWARD RISK
There are three different Preferences toward risk

● 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.

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Hot to determine whether a person is risk averter, lover or neutral

• Given: Initial Endowment of wealth (W)

• He faces a gamble of winning with probability of p
• Steps:
– Step 1: find the two income values
• W + h, if he wins
• W - h, if he losses
– Step 2: find utility of the expected income..UE(W)
– Step 3: find ?? the utility of the expected income
from the variable incomes ….EU(W)
• If UE(W) > EU(W)…….risk averse
• If UE(W) < EU(W)…….risk lover
• If UE(W) = EU(W)…….risk neutral

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 Risk Averter
• Is a person who hates risk
• Is a person who avoids even fair gambles
• He faces a concave utility function
• He has a diminishing marginal utility of money

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 Risk lover and risk neutral
• A risk lover person wants to take risk.
• The consumer faces a convex utility function
• MU increases
• EU (W) is greater than UE(W).
• He prefers the random distribution of wealth rather
than expected value of wealth
– U=W2
• A risk neutral person does not care about the riskiness
of his wealth at all but only about his expected value.
• A risk neutral consumer has a linear utility function
• EU (W) = UE(W).
• MU remains constant
– U =2W

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 (a) Risk Averter
Figure 2.1

Risk Aversion, Risk Loving,

and Risk Neutrality

In (a), a consumer’s marginal

utility diminishes as income
increases.

The consumer is risk averse

because she would prefer a
certain income of $20,000
(with a utility of 16) to a
gamble with a .5 probability of
$10,000 and a .5 probability of
$30,000 (and expected utility
of 14).
The expected utility of the
uncertain income is 14—an
average of the utility at point A
(10) and the utility at E (18)— 30
and is shown by F.

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 Figure2.2

Risk Aversion, Risk Loving,

and Risk Neutrality b) Risk c) Risk
In (b), the consumer is Loving Neutral
risk loving:

She would prefer the

same gamble (with
expected utility of 10.5) to
the certain income (with a
utility of 8).

In (c), the consumer is

risk neutral, and
indifferent between
certain and uncertain
events with the same
expected income.

● Expected utility Sum of the utilities associated with all possible

outcomes, weighted by the probability that each outcome will occur.

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 Risk Premium
● Risk premium Maximum amount of money that a risk-averse
person will pay to avoid taking a risk.
Figure 2.3
The risk premium, CF,
measures the amount of
income that an individual
would give up to leave her
indifferent between a risky
choice and a certain one.
Here, the risk premium is
$4000 because a certain
income of $16,000 (at point
C) gives her the same
expected utility (14) as the
uncertain income (a .5
probability of being at point
A and a .5 probability of
being at point E) that has
an expected value of
$20,000.

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 Risk premium
• It is the feature of a risk averse person.
• He is willing to pay some money to avoid the
risk he might face
• The amount of money that an individual is
willing to pay to avoid risk is known as risk
premium
• It is the amount of money that makes the
consumer indifferent between paying the
premium and facing the risk.
• U(E(W) - X) = EU(W)
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 Numerical Examples
1. The utility function of a consumer is given as U=2W1/2 with an initial
endowment of 60,000Birr. If he is involved in a game of fair gamble
which could lead to a win/loss of 40,000Birr, determine the attitude of
this consumer towards risk.
2. The utility function of a consumer is given as U=2W4 with an initial
endowment of 50Birr. If he has an equal chance of winning or losing 5Birr,
determine the attitude of this consumer towards risk.
3. The utility function of a consumer is given as U=W1/2 with an initial
endowment of 900Birr. If he is involved in a game of fair gamble which
could lead to a win/loss of 500Birr, determine how much the consumer is
willing to pay to avoid risk.
4. Utility function is given by 1/3W, initial endowment 600, and he/she has
a 90% chance of winning 200 and 10% chance of winning 50
a. Is the consumer risk averse, risk lover or risk neutral
b. Find E (W)
c. Find UE (w)
d. Find EU (W

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 REDUCING RISK
• Three possible measures for reducing risk
• Diversification
– Diversification is a practice of reducing risk by
allocating resources to a variety of activities whose
outcomes are not closely related.
• Insurance payment
• The Value of Information
• value of complete information is difference
between the expected value of a choice
when there is complete information and the
expected value when information is
incomplete

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