Chapter 3

Choice under Risk and

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Uncertainty

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3.1 Introduction
• Until now, we have been concerned with the behavior of a
consumer under conditions of certainty. However, many choices
made by consumers take place under conditions of uncertainty.
• In this chapter we explore how the theory of consumer choice can
be used to describe such behavior.
• Initially, considers the problem of an individual consumer facing an
uncertain environment.

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• It shows how preference structures can be extended to uncertain
situations and describes the nature of the consumer choice
problem.
• We then processed to derive the expected utility theorem,
• In the remaining sections, we discuss the concept of risk aversion,
and extend the basic theory by allowing utility to depend on states
of nature underlying the uncertainty as well as on the monetary
payoffs.
• Finally, We also discuss the theory of subjective probability. 2
 Definition of risk and Uncertainty
• Most economic decisions are made under conditions of risk and
uncertainty.
• Risk involves choices with multiple out comes where the
probability of each outcome is known or can be estimated.
• Uncertainty, on the other hand, involves situations involving

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multiple out comes in which the probability of each outcome is
unknown or cannot be estimated.
• To estimate the risk and uncertainty, we use
• Probability refers to the likelihood that an outcome will occur. In
our example, the probability that the oil exploration project is
successful might be 1/4 %,and the probability that it is
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unsuccessful 3/4.
• Probability is a difficult concept to formalize the
events because its interpretation can depend on
the nature of the uncertain events and on the
beliefs of the people involved.
• On objective interpretation of probability relies on
the frequency with which certain events tend to
occur.

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• Suppose we know that of the last 100 offshore oil
explorations 25 have succeeded and 75 have failed.
• Then the probability of success of 25% is objective
because it is based directly on the frequency of
similar experiences.
• But what if there are no similar past experiences to help
measure probability? 4
• Then,
• In these cases objective measures of probability
cannot be deduced, and a more subjective measure
is needed.
• Subjective probability is the perception that an
outcome will occur.
• This perception may be based on a person's
judgment or experience, but not necessarily on the

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frequency with which a particular outcome has
actually occurred in the past.
• When probabilities are subjectively determined,
different people may attach different probabilities to
different outcomes and thereby-make different
choices. 5
• For example, if the search for oil were to take place in an area
where no previous searches had ever occurred, I might attach
a higher subjective probability than you to the chance that
the project will be succeed because I know more about the
project, or
• because I have better understanding of the oil business and
can therefore make better use of our common information.
• Either different information or different abilities to process

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the same information can explain why subjective
probabilities vary among individuals.
• Whatever the interpretation of probability, it is used in
calculating two important measures that help us describe and
compare risky choices.
• One measure tells us the expected value
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• Expected Value

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3.2 Expected Utility Theory
3.2.1 Lotteries
• We shall imagine that the choices facing the consumer take the form
of lotteries.
• Suppose there are S states, associated with each state s is a
probability Ps representing the probability that the state s will occur
and a commodity bundle Xz representing the prize or reward that
will be won if the state s occurs,

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• The prizes may be money, bundles of goods, or even further
lotteries.
• A lottery is denoted by

• For instance, for two states, a lottery is given p ◦ x ⊕ (1 − p) ◦ y

which means: “the consumer receives prize x with probability p and 8
prize y with probability (1 − p).”
• Most situations involving behavior under risk can be put into
this lottery framework.
• Lotteries are often represented graphically in compound
form as in Figure below.

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• Several axioms (Assumption)about the consumers
perception of the lotteries

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• It can be represented in figure

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• Consider mathematical application for compounding
with example from exercise books page 1 and page 2 11
• For example: suppose we want to represent a situation with
three prizes x, y and z where the probability of getting each
prize is one third.
• By the reduction of compound lotteries, this lottery is
equivalent to the lottery

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• According to the compounding axiom (A3) above, the
consumer only cares about the net probabilities involved, so
this is indeed equivalent to the original lottery.
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 3.2.2 Expected Utility
• Under few additional assumptions, the theorem concerning
the existence of a utility function may be applied to show
that there exists a continuous utility function u which

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• The expected utility property says that the utility of a lottery
is the expectation of the utility from its prizes and such an
expected utility function is called von Neumann- 13
Morgenstern utility function.
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• Then, under those axioms, We can state the main theorem of
VMUF that u has the expected utility property. This follows from
some simple substitutions: see page 3

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• By the monotonicity axiom (A7), we must have u(x) > u(y).

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3.3 Risk aversion
• The term risk-averse refers to investors who, when faced with
two investments with a similar expected return, prefer the
lower-risk option
• A risk averse investor is an investor who prefers lower returns
with known risks rather than higher returns with unknown
risks.
• In other words, among various investments giving the same

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return with different level of risks, this investor always prefers
the alternative with least interest.
3.3.1 Absolute Risk Aversion
• Let us consider the case where the lottery space consists
solely of gambles with money prizes.
• We have shown that if the consumer’s choice behavior
satisfies Axioms 1-7, we can use an expected utility function
to represent the consumer’s preferences on lotteries. 17
• This means that we can describe the consumer’s
behavior over all money gambles by expected utility
function.
• For example, to compute the consumer’s expected
utility of a gamble
p ◦ x ⊕ (1 − p) ◦ y = pu(x) + (1 − p)u(y).

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• This construction is illustrated in Figure 4.3 ,see Slide
20, for p = 1/2
• Notice that in this example the consumer prefers to
get the expected value of the lottery. , Based on these
assumption, we can classify the Risk in the forms of
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Different Preferences Toward Risk
• Risk averse ;
• The utility of the lottery u(p ◦ x ⊕ (1 − p) ◦ y) is less than the
utility of the expected value of the lottery, px + (1 − p)y, Or
• U(X) < E (U(X)
• Risk neutral ;
• The utility of the lottery u(p ◦ x ⊕ (1 − p) ◦ y) is equal to the

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utility of the expected value of the lottery, px + (1 − p)[Link]
• U(X) equal to E (U(X)
• Risk loving ;
• The utility of the lottery u(p ◦ x ⊕ (1 − p) ◦ y) is grater than
the utility of the expected value of the lottery, px + (1 −
p)[Link]
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• U(X) > E (U(X)
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• If a consumer is risk averse over some region, the chord
drawn between any two points of the graph of its utility
function in this region must lie below the function.
• This is equivalent to the mathematical definition of a concave
function. Hence, concavity of the expected utility function is
equivalent to risk aversion.
• It is often convenient to have a measure of risk aversion.
Intuitively, the more concave the expected utility function,

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the more risk averse the consumer.
• Thus, we might think we could measure risk aversion by the
second derivative of the expected utility function.
• Risk Aversion can be
• 1. Absolute Risk Aversion.
• It helps to measure the degree for measurements of risk
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aversion
• if we normalize the second derivative by dividing by the
first, we get a reasonable measure, known as the Arrow-
Pratt measure of (absolute) risk aversion:

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• Consider mathematical application from exercise books of
example of VNMU page 5 to 7
• Page for Absolute risk Aversion from page 8

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 3.3.2 Global Risk Aversion
• The Arrow-Pratt measure seems to be a sensible
interpretation of local risk aversion: one agent is more risk
averse than another if he is willing to accept fewer small
gambles.
• What are natural ways to express this condition?
• The first plausible way is to formalize the notion that an agent
with utility function A(w) is more risk averse than an agent

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with utility function B(w) is to require that for all levels of
wealth w.
• This simply means that agent A has a higher degree of risk
aversion than agent B everywhere.

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• Another sensible way to formalize the notion that
agent A is more risk averse than agent B is to say that
agent A’s utility function is “more concave” than
agent B’s.
• More precisely, we say that agent A’s utility function
is a concave transformation of agent B’s; that is,
there exists some increasing, strictly concave

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function G(·) such that
A(w) = G(B(w)).
• The third way to capture the idea that A is more risk
averse than B is to say that A would be willing to pay
more to avoid a given risk than B would.
• See page 10 from ex book 24
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 3.3.3 Relative Risk Aversion
• Consider a consumer with wealth w and suppose that she/he
is offered gambles of the form: with probability p she will
receive x percent of her current wealth; with probability (1−p)
she will receive y percent of her current wealth.
• If the consumer evaluates lotteries using expected utility, the
utility of this lottery will be

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• For example, the return on investments is usually stated
relative to the level of investment.
• Just as before we can ask when one consumer will accept
more small relative gamble than another at a given wealth 26
level.
• Going through the same sort of analysis used above, we find
that the appropriate measure turns out to be the Arrow-Pratt
measure of relative risk aversion as

• It is reasonable to ask how absolute and relative risk aversions

might vary with wealth.
• It is quite plausible to assume that absolute risk aversion

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decreases with wealth: as you become more wealthy you
would be willing to accept more gambles expressed in
absolute dollars.
• The behavior of relative risk aversion is more problematic; as
your wealth increases would you be more or less willing to
risk losing a specific fraction of it?
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• See the detailed examples from Exercise book page 12

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Example : (Mean-variance utility)
• In general the expected utility of a gamble depends on the
entire probability distribution of the outcomes.
• However, in some circumstances the expected utility of a
gamble will only depend on certain summary statistics of the
distribution. In this case
• The most common example of this is a mean-variance utility
function. For example, suppose that the expected utility

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function is quadratic, it shows abnormal distribution of
income: so that u(w) = w − bw2.
• Then expected utility is

• Hence, the expected utility of a gamble is only a function of 29

the mean and variance of wealth.
• See the detailed examples from Exercise book
3.4 State Dependent Utility
• In our original analysis of choice under uncertainty, the prizes
were simply abstract bundles of goods; later we specialized
to lotteries with only monetary outcomes when considering
the risk aversion issue.
• However, this is restrictive. After all, a complete description of
the outcome of a dollar gamble should include not only the

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amount of money available in each outcome but also the
prevailing prices in each outcome.
• More generally, the usefulness of a good often depends on
the circumstances or state of nature in which it becomes
available.
• For Example:
• An umbrella when it is raining may appear very different to 30
a consumer than an umbrella when it is not raining.
• These examples show that in some choice problems it is
important to distinguish goods by the state of nature in which
they are available.
• For example,
• suppose that there are two states of nature, hot and cold,
which we index by h and c.
• Let xh be the amount of ice cream delivered when it is hot and
xc the amount delivered when it is cold.

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• Then,
• if the probability of hot weather is p, we may write a
particular probability as pu(h, xh, )+(1−p)u(c, xc).
• Here the bundle of goods that is delivered in one state is “hot
weather and xh units of ice cream,” and “cold weather and
xc, units of ice cream” in the other state. 31
• A good example involves it in the health insurance.
• The value of a dollar may well depend on one’s
health – how much would a million dollars be worth
to you if you were in a coma?
• In this case we might well write the utility function as
u(h,mh) where h is an indicator of health and m is
some amount of money.

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• These are all examples of state dependent utility
functions.
• This simply means that the preferences among the
goods under consideration depend on the state of
nature under which they become available.
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3.5 Subjective Probability Theory
• In the discussion of expected utility theory we have used
“objective” probabilities — such as probabilities calculated on
the basis of some observed frequencies
• And asked what axioms about a person’s choice behavior
would imply the existence of an expected utility function that
would represent that behavior.
• However, many interesting choice problems involve

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subjective probabilities: a given agent’s perception of the
likelihood of some event occurring.
• Similarly, we can ask what axioms about a person’s choice
behavior can be used to infer the existence of subjective
probabilities; i.e.,
• that the person’s choice behavior can be viewed as if he were
evaluating gambles according to their expected utility with
respect to some subjective probability measures. 33
• As it happens, such sets of axioms exist and are reasonably
plausible or acceptable.
• Subjective probabilities can be constructed in a way similar to
the manner with which the expected utility function was
constructed.
• Recall that the utility of some gamble x was chosen to be that
number u(x) such that

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• Suppose that we are trying to ascertain an individual’s
subjective probability that it will rain on a certain date.
• Then we can ask at what probability p will the individual be
indifferent between the gamble p ◦ b ⊕ (1 − p) ◦ w and the
gamble “Receive b if it rains and w otherwise.” 34
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• Unfortunately, real-life individual behavior appears to
systematically violate some of the axioms. Here, we present two
famous violation or paradoxes of expected utility: for examples.
• Example 1. (The Allais paradox) You are asked to choose between
the following two gambles:
• Gamble A. A 100 percent chance of receiving 1 million.
• Gamble B. A 10 percent chance of 5 million, an 89 percent chance of
1 million, and a 1 percent chance of nothing.
• Before you read any further pick one of these gambles, and write it

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down. Now consider the following two gambles.
• Gamble C. An 11 percent chance of 1 million, and an 89 percent
chance of nothing.
• Gamble D. A 10 percent chance of 5 million, and a 90 percent
chance of nothing.
• Again, please pick one of these two gambles as your preferred
choice and write it down.
• Many people prefer A to B and D to C. However, these choices 36
violate the expected utility axioms!
• To see this, simply write the expected utility
relationship implied by A ≽ B:
• u(1m) > .1u(5m) + .89u(1m) + .01u(0m).
• Rearranging this expression gives
• u(1m) - .89u(1m) > .1u(5m) + .01u(0m).
• .11u(1m) > .1u(5m) + .01u(0m),

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• and adding .89u(0) to each side yields from gamble C
• 11u(1m) + .89u(0m )> .1u(5m) + .01u(0m) + .89u(0m)
• .11u(1m) + .89u(0m) > .1u(5m) + .90u(0m),
• Practically from results, It follows that gamble C
must be preferred to gamble D by an expected utility
maximize, but not D to C 37
• Example 2, (The Ellsberg paradox) The Ellsberg paradox
concerns subjective probability theory.
• You are told run the jar contains 300 balls. One hundred of the
balls are red and 200 are either blue or green.
• Gamble A. You receive$1, 000 if the ball is red.
• Gamble B. You receive $1, 000 if the ball is blue.
• Write down which of these two gambles you prefer.
• Now consider the following two gambles:

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• Gamble C. You receive $1, 000 if the ball is not red.
• Gamble D. You receive $1, 000 if the ball is not blue.
• It is common for people to strictly prefer A to B and C to D.
• But these preferences violate standard the assumption.

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• To see why, let R be the event that the ball is red, and ￢R be
the event that the ball is not red, and define B for blue and
￢B for not blue accordingly.

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• Opinions differ about the importance of the Allais
paradox and the Ellsberg paradox.
• Some economists think that these anomalies(
differences or variances) require new models to
describe people’s behavior.
• Others think that these paradoxes are akin or like

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or parallel to “optical illusions.”
• Even though people are poor or low understanding
at judging distances under some circumstances
doesn’t mean that we need to invent a new concept
of distance.

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 •The End

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