Finals Microeconomics: MT11

Lectures on Risk and Expected utility:Lecture 2

Sujoy Mukerji
Oxford University

November 15, 2011

Sujoy Mukerji

(Oxford University )

UGFnlsMicroRiskMT11

November 15, 2011

1 / 14

The insurance decision

We wish to understand what drives the demand for insurance. When a consumer buys insurance she swaps a (part of a) random income for a sure income. If she were risk averse she will value the random income she is giving up in the exchange at less than its expected value. If the insurance company were less risk averse than her (say, almost risk neutral) than it would value the random income being being oered at close to its expected value. Hence, the possibility of gains from trade. This basic idea should be evident from our now familiar diagram of a risk averse agent s utility from a random payo.

Sujoy Mukerji

(Oxford University )

UGFnlsMicroRiskMT11

November 15, 2011

2 / 14

The insurance decision

More precisely, Suppose a risk averse agent s endowment/wealth is random; in "normal" times it is w , but there is a chance (1 p ) that she suers a loss L. The insurance company is willing to indemnify the agent for the entire amount of the loss upon the payment of an Insurance Premium up front. What is the most the agent will be willing to pay as Insurance premium?

Sujoy Mukerji

(Oxford University )

UGFnlsMicroRiskMT11

November 15, 2011

3 / 14

The insurance decision

utils u(.) u(E(w)) Eu(w)

Indemnity

Insurance Premium RP
W-L

Wealth is random Wealth with no loss

CE(.)

E(wealth)

Final wealth

Wealth following loss

Sujoy Mukerji

(Oxford University )

UGFnlsMicroRiskMT11

November 15, 2011

4 / 14

The insurance decision

Hence, the most the agent is willing to pay as insurance premium (for an indemnity that equals the entire loss) is w CE (endowment ). If she were to pay the maximum amount (she is willing to) to buy insurance, in the the normal times the agent ends up with w [w CE (endowment )] = CE (endowment ). In case loss occurs, she ends ups with w L + L (w CE (endowment )) = CE (endowment ). She thus ends up with sure income which worth the same to her as her random endowment. Notice, if the insurance is purchased for an amount x , where E (endowment ) > x > CE (endowment ) and the insurance company is (close to) risk neutral, then both agent and insurance agent are left strictly better o by the swap.
Sujoy Mukerji (Oxford University ) UGFnlsMicroRiskMT11 November 15, 2011 5 / 14

The insurance decision

Two questions remain:

What allows the insurance company behave as if it were (almost) risk neutral? What if the insurance decision is not a 1-0 decision; i.e., you can buy variable amounts of indemnity (i.e. variable amount of coverage) at a given per unit rate of insurance premium?

We will turn to the second question now, leaving the rst question for the next lecture.

Sujoy Mukerji

(Oxford University )

UGFnlsMicroRiskMT11

November 15, 2011

6 / 14

The insurance decision

We may model the second question, algebraically as follows: max p1 u (w
i 0

qi ) + p2 u (w

L+i

qi )

where i is the units of indemnity purchased and q is the price (the insurance premium) per unit of indemnity (or, coverage). The rst order condition: qp1 u 0 (w qi ) + (1 q ) p2 u 0 (w L + i qi ) = 0 p1 u 0 (w qi ) (1 q ) , = 0 p2 u (w L + i qi ) q

Sujoy Mukerji

Second order condition is satised if u 00 (.) < 0. 1 q 1 Notice, in case p p 2 = q then i = L (i.e., full insurance) solves the equation. For more general insight, we will use another graphical device, the state-contingent payo space representation of preferences and opportunity sets.
(Oxford University ) UGFnlsMicroRiskMT11 November 15, 2011

7 / 14

A state contigent payo space

A state of the world/nature is a realization of aairs, a resolution of uncertainty, that xes the outcome of an action with uncertain consequences e.g.: loss or no loss (in insurance purchase example) describles two possible states; movie A is good/bad and/or movie B is good/bad describes four possible (payo relevant) states A state contingent payo space, shown on the next slide, consists of points (e.g., x (x1 , x2 )) each describing a particular state contingent consumption vector. In that diagram, think of state 1 and 2 as having probabilities p1 and p2 respectively. On the diagram we describe preferences of two agents, one risk neutral (red) and another risk averse (blue), using indierence curves, e.g., the ones passing through the point x (x1 , x2 ) .
Sujoy Mukerji (Oxford University ) UGFnlsMicroRiskMT11 November 15, 2011 8 / 14

A state contigent payo space

Payoff in state 2

p1x1 + p2 x2 = k
45o

slope = -

p1 p2

p1u( x1 ) + p2u ( x2 ) = u

x2

Payoff in state 1

x1
Sujoy Mukerji (Oxford University ) UGFnlsMicroRiskMT11 November 15, 2011 9 / 14

The insurance decision reconsidered

Let us revisit the insurance purchase decision using the indierence curves in the state contignet payo space. The two states of nature are the event that the loss does not occur (state 1) and the event that the loss occurs (state 2). The state contigent payo vector (w , w L) represents the random endowment. Let i be the units of indemnity purchased at price per unit q . If you purchase i dollars of indemnity you are giving up qi in state 1 in exchange for i qi in state 2: c2 = c1 i qi qi

1 q

This is the slope of the budget line describing the insurance opportunity on oer. It is just as if the price of consumption in the good state is (1 q ) and the price in the bad state is q .
Sujoy Mukerji (Oxford University ) UGFnlsMicroRiskMT11 November 15, 2011 10 / 14

The insurance decision reconsidered

We say the rate of insurance premium q is "fair" if on the average the insurance company just breaks even on the insurance contract. That is, p1 qi + p2 (qi i ) = 0 , q = p2 . In this case the slope of the budget line describing the insurance opportunity on oer 1 q q

p2 p2

p1 . p2

Just like the slope of an indierence curve of a risk neutral agent (or, the slope of a risk averse agent on the certainty (450 line).

Sujoy Mukerji

(Oxford University )

UGFnlsMicroRiskMT11

November 15, 2011

11 / 14

The insurance decision reconsidered

Payoff in state 2
45o

p1u ( x1 ) + p2 u ( x2 ) = u

slope = -

p1 p2

F G

slope =

1 q p = 1 q p2 slope = 1 q p1 < q p2

w L

E
w

Payoff in state 1
Sujoy Mukerji (Oxford University ) UGFnlsMicroRiskMT11 November 15, 2011 12 / 14

Why is expected utility reasonable?

The expected utility formulation of agent s preferences over risky alternatives is a convenient one, but is it a reasonable one? The crucial/distinctive assumption underpinning the theory of expected utility is the independence axiom: Given any three lotteries, `1 , `2 , `3 ,

`1

% ( ) `2 , `1 + (1

) `3 % ( ) `2 + (1

) `3

where is a number between 0 and 1, representing a probability. Hence, `1 + (1 )`3 is a compound lottery (a lottery whose consequence is also a lottery).

Sujoy Mukerji

(Oxford University )

UGFnlsMicroRiskMT11

November 15, 2011

13 / 14

Why is expected utility reasonable?

As an example, think of three lotteries `1 , `2 , `3 , as, a mug of coee, a mug of beer and a spoonful of sugar, each with probability one, respectively. Crucially, these outcomes are realised (in the compound lotteries) as mutually exclusive events. Implies tradeo across states is independent of the consumption in any third state, as is evident in the expected utility formula: U (x1 , x2 , x3 )

= p1 u (x1 ) + p2 u (x2 ) + p3 u (x3 ) p1 u 0 (c1 ) ) MRS1,2 = p1 u 0 (c2 )

MRS depends only on how much you have of (contingent) goods 1 and 2, not on howmuch you have of good 3. Clearly, rules out complementaries etc. between consumption across states. Makes sense because states are mutually exclusive events.
Sujoy Mukerji (Oxford University ) UGFnlsMicroRiskMT11 November 15, 2011 14 / 14