CHAPTER TWO
CHOICE UNDER UNCERTAINTY
Ø Introduction
ü Traditional demand theory implicitly assumed a risk less world
• Complete certainty as to the results of the choices they make.
ü Uncertainty refer to a situation when there are more than one possible outcomes to a
decision and where the probability of each specific outcome is not known.
ü Risk refers to a situation where there is more than one possible outcome to a decision and
the probability of each specific outcome is known or can be estimated.
ü Certainty refers to a situation where there is only one possible outcome to a decision and
this outcome is known precisely.
Cont’d
ü Measurement and comparing risks
i. Expected value: is the weighted average of all possible payoffs/outcomes with the
probability of those payoffs used as weights.
ii. Variability: is the extent to which possible outcomes of an uncertain event may differ.
ü Standard deviation, measures the dispersion of possible outcomes from the expected
value, is the often used measure of variability.
ü Smaller value of SD implies tighter distribution and lower risk attached to it, vice versa.
ü If two alternatives to choose from have the same expected value, the one with smaller
standard deviation is less risky and hence is preferred.
Ø Different Preferences towards Risk
i. Risk Averse Person: preferring a certain income to a risky with same expected value.
ü For such person losses are more important (in terms of the change in utility) than gains.
ü Losses hurt him/her more seriously than gains benefit him/her.
ü Thus, the MU of income diminishes as income rises; Concave utility function
ü The maximum amount of money that a risk averse person will pay to avoid taking a risk
is called a risk premium.
Figure 1. Utility graph of a risk-averse person
Cont’d
ii. Risk Neutral Person: a person indifferent between certain and an uncertain income with the
same expected value.
ü For this person, the MU of income is constant.
Figure 2. Utility graph of a risk-neutral person
Cont’d
iii. Risk Loving Person: preferring a risky income to a certain with the same expected value.
ü Prefers an uncertain income to a certain one, even if the expected value of the uncertain
income is less than that of the certain income.
ü The expected utility of the uncertain income is greater than the utility of a certain
ü Utility of income curve is upward bending
Figure 3. Utility graph of a risk-loving person
Cont’d
ü Risk loving people are few, at least with respect to major purchases or large amounts of
income or wealth.
ü 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).
NB: Expected utility E(U) is the sum of the utilities associated with all possible outcomes,
weighted by the probability that each outcome will occur.
Ø Risk Aversion and Indifference Curves
ü An IC shows the combination of expected income and standard deviation of income that
give the individual the same amount of utility.
ü Since risk is undesirable; the greater the amount of risk, the greater the amount of income
needed to make the individual equally well-off, this makes ICs upward sloping.
ü An increase in the SD (higher variability) of income must be compensated by a higher
expected income so as to a very leave a risk averse person on the same level of utility.
Ø Reducing Risk
ü In the face of a broad variety of risky situations, people are generally risk averse.
i. Diversification: - reducing risk by allocating resources to a variety of activities which
outcomes are not closely related
§ “Don’t put all your eggs in one basket.”
i. 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.
ii. 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.