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Uncertainty and Consumer Behavior - Chapter 5

This document discusses uncertainty and risk from a consumer behavior perspective. It begins by defining key concepts related to quantifying and describing risk such as probability, expected value, payoff, and variability. It then examines people's preferences toward risk, distinguishing between risk averse, risk neutral, and risk seeking preferences. Finally, it discusses ways people can reduce risk, such as through diversification and insurance. The goal is to understand how consumers compare and make choices under conditions of uncertainty.

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295 views

Uncertainty and Consumer Behavior - Chapter 5

This document discusses uncertainty and risk from a consumer behavior perspective. It begins by defining key concepts related to quantifying and describing risk such as probability, expected value, payoff, and variability. It then examines people's preferences toward risk, distinguishing between risk averse, risk neutral, and risk seeking preferences. Finally, it discusses ways people can reduce risk, such as through diversification and insurance. The goal is to understand how consumers compare and make choices under conditions of uncertainty.

Uploaded by

rizzz
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Uncertainty and

Consumer Behavior
Chapter 5
CHAPTER 5 OUTLINE

 5.1 Describing Risk

 5.2 Preferences Toward Risk

 5.3 Reducing Risk


Uncertainty and Consumer Behavior
 To examine the ways that people can compare and
choose among risky alternatives, we will take the following
steps:
1. In order to compare the riskiness of alternative choices,
we need to quantify risk.

2. We will examine people’s preferences toward risk.

3. We will see how people can sometimes reduce or


eliminate risk.
4. In some situations, people must choose the amount of risk
they wish to bear.
Describing Risk
 Probability Likelihood that a given outcome will occur
 Subjective probability is the perception that an outcome will occur.
 Expected value Probability-weighted average of the payoffs
associated with all possible outcomes.
 Payoff Value associated with a possible outcome
 The expected value measures the central tendency—the payoff or
value that we would expect on average.
 Expected value = Pr(success)($40/share) + Pr(failure)($20/share)
 = (1/4)($40/share) + (3/4)($20/share) = $25/share
 More Generally:
 E(X) = Pr1X1 + Pr2X2
 E(X) = Pr1X1 + Pr2X2 + . . . + PrnXn
DESCRIBING RISK
 variability Extent to which possible outcomes of an uncertain event differ.

OUTCOME 1 OUTCOME 2
Expected
Probability Income ($) Probability Income ($) Income ($)

Job 1: Commission .5 2000 .5 1000 1500


Job 2: Fixed Salary .99 1510 .01 510 1500

 deviation Difference between expected payoff and actual payoff

TABLE 5.2 Deviations from Expected Income ($)

Outcome 1 Deviation Outcome 2 Deviation

Job 1 2000 500 1000 500


Job 2 1510 10 510 990
 Standard deviation Square root of the weighted average of the squares of
the deviations of the payoffs associated with each outcome from their expected
values.
 Calculating Variance

Outcome Deviation Outcome Deviation Weighted Standard


1 Squared 2 squared Average Deviation
Deviation
Squared
Job 1 2000 250000 1000 250000 250000 500

Job 2 1510 100 510 980100 9900 99.50


Outcome Probabilities for Two Jobs

 The distribution of payoffs associated with Job 1 has a greater spread and a
greater standard deviation than the distribution of payoffs associated with Job
2.
 Both distributions are flat because all outcomes are equally likely
Preferences Towards Risks

 Risk Averse, Risk Loving, and Risk Neutral


 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).
Risk Averse and Risk Neutral

Expected Utilities: Sum of the utilities associated with all


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

 Risk premium Maximum amount of money that a risk-averse person will pay to
avoid taking a risk
 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
Risk Aversion and Income
 The extent of an individual’s risk aversion
depends on the nature of the risk and on the
person’s income.

 Other things being equal, risk-averse people


prefer a smaller variability of outcomes.

 The greater the variability of income, the more


the person would be willing to pay to avoid the
risky situation.
Risk Aversion and Indifference Curve
 Part (a) applies to a person who is highly risk averse:
 An increase in this individual’s standard deviation of income requires a large
increase in expected income if he or she is to remain equally well off.

 Part (b) applies to a person who is only slightly risk averse:


 An increase in the standard deviation of income requires only a small
increase in expected income if he or she is to remain equally well off.
Reducing Risk
 Diversification Practice of reducing risk by allocating
resources to a variety of activities whose outcomes are not
closely related.
 Stock Market:
 mutual fund Organization that pools funds of individual
investors to buy a large number of different stocks or other
financial assets.
 Insurance
 The Law of Large Numbers
 The ability to avoid risk by operating on a large scale is based
on the law of large numbers, which tells us that although single
events may be random and largely unpredictable, the average
outcome of many similar events can be predicted.
Insurance While Buying House
 Suppose you are buying your first house. To close the sale, you will
need a deed that gives you clear “title.” Without such a clear title, there
is always a chance that the seller of the house is not its true owner.
 In situations such as this, it is clearly in the interest of the buyer to be
sure that there is no risk of a lack of full ownership.

 The buyer does this by purchasing “title insurance.”

 Because the title insurance company is a specialist in such insurance


and can collect the relevant information relatively easily, the cost of title
insurance is often less than the expected value of the loss involved.

 In addition, because mortgage lenders are all concerned about such


risks, they usually require new buyers to have title insurance before
issuing a mortgage.
The Value of Information

 Value of complete information Difference between the


expected value of a choice when there is complete
information and the expected value when information is
incomplete.
Doctors, Patients and the Value of
Information
 Suppose you were seriously ill and required major surgery.
Assuming you wanted to get the best care possible, how would
you go about choosing a surgeon and a hospital to provide that
care?

 A truly informed decision would probably require more detailed


information.
 This kind of information is likely to be difficult or impossible for
most patients to obtain.
 However, information can cause people to change their
behavior in undesirable ways.

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