Uncertainty

Lecture 1 – Tom Holden Intermediate Microeconomics Semester 2

http://micro2.tholden.org/

ECO2051 – Intermediate Microeconomics

Introduction to Semester 2
• In the second half of the module we relax some of the assumptions of the perfectly competitive model. • This leads us to consider the role of government intervention. • And consider some interesting ways that individuals and firms respond to uncertainty and imperfect information. • As last semester, you will need to be able to solve problems but I also expect you to be able to discuss the implications of the theory for real life behaviour and policy.

ECO2051 – Intermediate Microeconomics

2

Key info (1/4): Contact details
• Course website: http://micro2.tholden.org/ • Email
• Me: t.holden@surrey.ac.uk • Your class tutor, Tina Tse: t.tse@surrey.ac.uk

• Office hours:
• Thursday, 2 – 4.
• E-mailing in advance is always helpful.

• Other times may be possible by (e-mail) arrangement.

• Classes:
• Thursdays (10-11 and 11-12)

ECO2051 – Intermediate Microeconomics

3

Key info (2/4): Readings
• Main text:
• V = Varian, H. (2006) Intermediate Microeconomics: A Modern Approach, Seventh edition, Norton. • Other editions fine, just use the contents to find the right chapter.

• Alternative:
• MKR = Morgan, Katz and Rosen Microeconomics (2nd European edition) McGraw-Hill, 2009.

• Additional exercises:
• Bergstrom and Varian, Workouts in Intermediate Economics

ECO2051 – Intermediate Microeconomics

4

Key info (3/4): Draft timetable Week 1 2 3 4 5 6 7 8 9 10 11 Date w/c 4/2 11/2 18/2 25/2 4/3 11/3 18/3 22/4 29/4 6/5 13/5 Topic Uncertainty 1 Uncertainty 2 + Welfare 1 Welfare 2 Externalities Public goods Inter-temporal choice Multiple Choice Test (10%) Asymmetric Information Asymmetric Information 2 Auctions Short answer test (20%) Revision and feedback on test Basic Readings V 12. Public goods and inter-temporal choice V 17 MKR 17 4. Auctions and Revision ECO2051 – Intermediate Microeconomics 5 . p. Welfare and externalities 3.154) V 37 MKR 17 Problem set 1. MKR 6 V 33 MKR 12 (esp. MKR 5 (from p. MKR 18 V 36 MKR 18 V 10. Uncertainty 2. Asymmetric information 5.446 onwards) V 34.

3 sections. Sample test given in week 9. (Similar style questions to test 2. On material from all weeks. Mock exam given out in week 11. • Test 2: • • • • • • • • • • • • • • Answer 3 short-answer questions from 6. (Should only take around 1. 60 minutes.) Section C asks you to answer 1 longer question from 3. Actual test in week 7. On material from weeks 1-6.Key info (4/4): Draft assessment plan • Test 1: • • • • • • 20 question multiple choice. equal weights. Worth 10%. Actual test in week 10.) Section B is compulsory short answer questions. • Exam: ECO2051 – Intermediate Microeconomics 6 . Section A is multiple choice. but with a focus on the second half of the course. 2 hours. On material from all weeks. Worth 70%. Sample test given in week 6.) Worth 20%. (Similar style questions to test 1. Up to 2 hours.

• Bergstrom and Varian’s Workouts provide many additional exercises.Expectations • As well as mastering the concepts discussed in the lectures. • Please let me know if there are any problems. you need to practice the techniques we cover. but you will need to work on the problem sets before the class. • I will cover one or two problems in each lecture as an introduction. or if anything can be done to improve the running of the course. ECO2051 – Intermediate Microeconomics 7 . Do come to me in the first instance.

Introduction • Uncertainty is pervasive. • Many of the choices we make include a element of risk. • Economic theory can help us to understand the choices made in situations where there is risk. • Examples: • • • • Career choices Insurance markets Investments Gambling ECO2051 – Intermediate Microeconomics .

• To understand risk aversion and risk-seeking. • To consider examples where EUT provides insights • Insurance • Investment • To consider the Ellsberg. Allais and St.Topic objectives • To learn the language of expected utility theory. Petersburg paradoxes. ECO2051 – Intermediate Microeconomics .

Katz and Rosen. Chapter 6 ECO2051 – Intermediate Microeconomics . Chapter 12 • Morgan.Reading • Varian.

If the second toss is tails you win £4 and the game ends. • Otherwise we toss again. • If the third toss is tails you win £8. is heads.The St. £32. we toss again. and the game ends. Petersburg Paradox (1/3) • How much would you pay to play the following lottery? • • • • I will repeatedly toss a coin. you win £2. If the first toss comes up tails. • And so on… (£16. If the first toss. £64…) ECO2051 – Intermediate Microeconomics .

• You have a probability of × × of getting £8. Petersburg Paradox (2/3) • You have a probability of of getting £2.The St. • Etc. • You have a probability of × = of getting £4. • So your expected return in pounds is • ×2+ ×4+ ×8+⋯=1+1+1+⋯=∞ 1 2 1 4 1 8 1 2 1 2 1 4 1 1 = 2 8 1 2 1 2 1 2 ECO2051 – Intermediate Microeconomics .

the money will be donated to the Surrey Economic Society. ECO2051 – Intermediate Microeconomics . • One slight modification: • The most I will pay out is twice the amount you pay me for the right to play. let’s play this game for real. Petersburg Paradox (3/3) • So. if you pay me £10 for the right to play.The St. • If I make a profit. • So. the most I will pay out is £20 (so you double your money).

ECO2051 – Intermediate Microeconomics . • This means that we can apply the tools of straight-forward consumer theory (budget constraints and indifference curves) to situations that involve uncertainty.The foundations of expected utility theory • The basis for EUT is the assumption that individuals are just as capable of making choices between uncertain consumption bundles as they are between certain bundles of goods.

• If I buy a lottery ticket then I will lose £1 if none of my numbers come up and gain £1000000 if it is the winning ticket. • The consumption received depends on the outcome of a random event – this is referred to as the STATE OF NATURE. • For example: • The choice over whether or not to buy a lottery ticket.The language of uncertainty • Generally uncertainty is discussed in terms of money as proxy for composite consumption. • The CONTINGENT CONSUMPTION PLAN is a statement of the consumption that occurs in each state of nature. We attach some probably to this. • If I do not buy a lottery ticket my wealth will remain the same. ECO2051 – Intermediate Microeconomics .

ECO2051 – Intermediate Microeconomics . • In EUT the budget constraint shows how much consumption in state of the world 1 you can trade for consumption in state of the world 2. • You keep the £1 if you win and lose it if you lose. • A £1 bet on the turn of a card gives 40𝑝 if it’s not a heart.Drawing the budget constraint • In straightforward consumer theory the budget constraint shows how much of good 1 you can trade for good 2. • Need to decide how much to bet.

0.4 Endowment 1 Budget constraint could be extended if the individual could offer the same bet to others Consumption if heart ECO2051 – Intermediate Microeconomics .The budget constraint for a gamble Consumption if not heart Slope is −0.4 which is the cost of gaining 1 when a heart does appear in terms of loss when a heart does not appear.

• Would need to lower the prize slightly to generate a ‘fair’ gamble.75 + −1 × 0.25 = 0.4 × 0.75 + −1 × 0.33 × 0.30 − 0.25 = 0. ECO2051 – Intermediate Microeconomics . Draws a line between all the possible expected values. • In which case we can work out the expected net value of the gamble: • 0.25 = 0 • The budget constraint for a fair gamble gives the ‘fair-odds’ line.25 = 0.But so we far we haven’t mentioned probability • We know that the chance of an individual winning the bet is 3 in 4.05 • The expected net value of this gamble is positive.25 − 0. • If the prize was 33𝑝 the expected value would be: • 0.

0.33.33 Endowment 1 Consumption if heart ECO2051 – Intermediate Microeconomics .The ‘fair-odds’ line Consumption if not heart We showed that the expected value of the gamble is zero when the payoff to not heart is 0.

• What would the budget constraint look like? • What’s the expected value of the gamble? • How would we need to change the game to make the gamble actuarially fair? ECO2051 – Intermediate Microeconomics .Another example • In this case we’re gambling on the throw of a dice. • If it’s a six receive 4 times the stake (and keep the stake). • Otherwise the stake is lost.

The ‘fair-odds’ line for the die game 5 𝑝 = 6 Consumption if six 1 6 Slope= −5 1 − 𝑝 = 5 Endowment 1 Consumption if not six ECO2051 – Intermediate Microeconomics .

1−𝑝 where 𝑝 is the probability of the event occurring. ECO2051 – Intermediate Microeconomics . • Why?!? 6 4 5 𝑝 1 1 • We generally put the worse outcome on the horizontal axis.In the general case • The fair odds line gives the slope of the budget constraint when the expected value is zero. • The fair odds line has slope given by minus the odds of the outcome on the horizontal axis. • The odds of an outcome occurring is the probability it occurs divided by the probability it does not occur. • I. • Notice that the actual budget constraint for the gamble and the fair-odds line need not be the same. • The odds of “heart” is 3 4 = 3.e. • The odds of “not six” is 1 6 = 5. but we need not.

of course they would prefer to win the gamble.Next: preferences • Choices are made over contingent commodities ‘bundles’ of goods as represented by points on the budget line. • The individual is not making a choice about the state of the world. but that choice isn’t theirs to make. ECO2051 – Intermediate Microeconomics . • In the examples we have been considering the choice is over how much to gamble.

1 − 𝑝1 is the probability of state 2.The expected utility function • The utility function for consumption in states of the world 1 and 2 is • 𝑈 𝑐1 . 𝑐2 is consumption in state 2. • The utility of a contingent consumption plan depends on consumption in the two states of the world and the probability of each state of the world occurring. 𝑐2 . ECO2051 – Intermediate Microeconomics . 𝑝1 • where 𝑐1 is consumption in state 1. 𝑝1 = 𝑝1 𝑢 𝑐1 + 1 − 𝑝1 𝑢 𝑐2 • Expected utility is a weighted average of the utility of the two possible consumptions with the weighting dependent on the probabilities. 𝑝1 is the probability of state 1. • The expected utility form is: • 𝑈 𝑐1 . 𝑐2 .

• An expected utility function is also known as von-NeumannMorgenstern (vNM) utility function. 𝑝1 = 𝑝1 log 𝑐1 + 1 − 𝑝1 log 𝑐2 𝑝 1−𝑝 ECO2051 – Intermediate Microeconomics . 𝑝1 = 𝑐1 1 𝑐2 1 is a vNM utility function. • Cobb-Douglas utility 𝑈CD 𝑐1 . since: log 𝑈CD 𝑐1 . • Contrast with normal utility functions. despite appearances. 𝑐2 . 𝑐2 .More on expected utility • The expected utility function 𝑢 ∙ is ‘unique up to an affine transformation’ which means you can add a constant and multiply by a positive number and the preferences which result won’t change.

ECO2051 – Intermediate Microeconomics . • This is known as the independence axiom. • Once the state of the world is known you will only care about consumption in the SoW that prevails.Why does it make sense? • The additive nature of the expected utility function means that the utility derived from the consumption in each state of the world is independent of consumption in the other state of the world. the other will be irrelevant.

𝑐2 . 𝑐3 = 𝑝1 𝑢 𝑐1 + 𝑝2 𝑢 𝑐2 + 𝑝3 𝑢 𝑐3 • where 𝑝1 + 𝑝2 + 𝑝3 = 1. • Consider the MRS between consumption in state 1 and state 2: • MRS12 = 𝜕𝑈 𝜕𝑐1 𝜕𝑈 𝜕𝑐2 = 𝑝1 𝑢′ 𝑝2 𝑢′ 𝑐1 𝑐2 • The MRS for consumption in SoW 1 and consumption in SoW 2 does not depend on what consumption is in SoW 3. ECO2051 – Intermediate Microeconomics .Illustration of independence • Suppose utility is given by: • 𝑈 𝑐1 .

Do you have vNM preferences? The Allais Paradox Experiment 1 Experiment 2 Gamble 1A Gamble 1B Gamble 2A Gamble 2B Winnings £1 Chance 100% Winnings £1 £0 Chance 89% 1% Winnings £0 £1 Chance 89% 11% Winnings £0 Chance 90% £5 10% £5 10% Evidence for Prospect Theory??? Derived from: https://en.wikipedia.org/wiki/Allais_paradox ECO2051 – Intermediate Microeconomics .

ECO2051 – Intermediate Microeconomics . and with probability 1 − 𝑝 I run gamble “C”. • Then if I offer you a choice between the following two new gambles: • Gamble D: With probability 𝑝. • Gamble E: With probability 𝑝.g. • And suppose “C” is a third gamble.g. “A” (e. “B” (e. I run gamble “A”. • Which do you prefer? • The independence axiom is the assumption that you will always prefer D here. the dice one).Formal definition of the “independence axiom” • Suppose you prefer taking part in one gamble. the hearts one) to taking part in another. and with probability 1 − 𝑝 I run gamble “C”. I run gamble “B”.

Gamble 2A: You receive £1 if you draw a red or a yellow ball. • You do not know how many are black or how many are yellow. ECO2051 – Intermediate Microeconomics . Gamble 1B: You receive £1 if you draw a black ball. • Consider the following four gambles: • • • • Gamble 1A: You receive £1 if you draw a red ball. Gamble 2B: You receive £1 if you draw a black or a yellow ball.Do you have vNM preferences? The Ellsberg Paradox • Suppose there is an urn containing: • 33 red balls • 66 balls that are a mix of black and yellow.

g.75 × 𝑢 14 + 0. • Therefore the expected value of the gamble is £10. 0.More on vMN preferences: An important distinction • Back to first example. this is 10.24 • Risk averse agents prefer to get the expected value of a gamble with certainty.25 × 𝑢 0 • E. Assume £10 bet.50. if 𝑢 𝑥 = 𝑥. • 0. this is 0. • The expected utility from the gamble is: • 0.5 ≈ 3.g.75 chance of having £14.81 • The utility from the expected value of a gamble is 𝑢 10.5 • E.25 × 0 ≈ 2.25 chance of having £0.75 × 14 + 0. ECO2051 – Intermediate Microeconomics . if 𝑢 𝑥 = 𝑥.

e.25 × 𝑢 0 Notice that the expected utility of the gamble is lower than the utility of the expected value.5 14 consumption ECO2051 – Intermediate Microeconomics .5 0.75 × 𝑢 14 + 0. 𝑢 𝑝1 𝑐1 + 𝑝2 𝑐2 > 𝑝1 𝑢 𝑐1 + 𝑝2 𝑢 𝑐2 This is the definition of risk aversion.Risk aversion Utility 𝑢 14 𝑢 10. I. 𝑢 0 0 10.

𝑢 𝑝1 𝑐1 + 𝑝2 𝑐2 < 𝑝1 𝑢 𝑐1 + 𝑝2 𝑢 𝑐2 𝑢 0 What would risk neutral utility look like? 0 10.Risk loving Utility 𝑢 14 0.75 × 𝑢 14 + 0.e. This is preferring gambles over getting their expected value for certain.5 It is also possible to be risk loving. the opposite of risk aversion. I.5 14 consumption ECO2051 – Intermediate Microeconomics .25 × 𝑢 0 𝑢 10.

• There is a declining marginal utility of income. • This is why a risk averse person would not want to take an actuarially fair gamble. • Empirical work suggests 𝑢 𝑥 = log 𝑥 is a reasonable approximation to most people’s utility. ECO2051 – Intermediate Microeconomics .Risk aversion and marginal utility • Notice that a risk averse utility function is concave. • As a consequence income lost has more impact than income gained. • Each extra £1 is worth less the richer you become.

Indifference curves with risk aversion We would expect ICs to be convex: prefer a mix of consumption in both periods. Certainty line Consumption if not heart 45° Fair odds line (slope= − 3) Consumption if heart appears ECO2051 – Intermediate Microeconomics 1 . This captures risk aversion.

Why? Certainty line Consumption if not heart A B 45° Fair odds line (slope= − 3) Consumption if heart appears ECO2051 – Intermediate Microeconomics 1 .Indifference curves with risk aversion Risk aversion rules out indifference curves like the following one.

• A risk averse person always chooses equal consumption in both states of the world if offered fair odds. • Therefore by the definition of risk aversion. • Indifference curves must be tangential to the fair odds line. ECO2051 – Intermediate Microeconomics . A must be preferred.Indifference curves with risk aversion • Point A and point B have the same expected return. • But point A is a certainty.

• What will happen in the case of a risk lover? ECO2051 – Intermediate Microeconomics . • The individual chooses the contingent consumption bundle which maximises his utility given the budget constraint he faces.In equilibrium • Equilibrium follows exactly as it would in all other situations. • So a risk averse consumer will not accept an actuarially fair gamble.

5 0.25 × 𝑢 0 Risk premium is what you’d need to be paid to be compensated for taking the risk.75 × 𝑢 14 + 0. 𝑢 0 0 𝑢−1 0.5 14 consumption Risk premium .Risk premia Utility 𝑢 14 𝑢 10.25 × 𝑢 0 10.75 × 𝑢 14 + 0. It’s calculated as the difference between what you’d be willing to pay for the gamble and its expected value.

Certainty line B A’ Risk premium 45° A Fair odds line ECO2051 – Intermediate Microeconomics .Or with indifference curves Fair odds line shows expected values. Would need to be compensated by the length of A’B for being at A rather than B even though expected value is the same.

• You have £1000 to spend on consumption if you don’t bet.Example of optimisation (For next week perhaps) • Odds on Arsenal winning the premier league 10 to 1. ECO2051 – Intermediate Microeconomics . • Your von-Neumann-Morgenstern utility function is 𝑝1 𝑐1 + 1 − 𝑝1 𝑐2 • How much should you bet? • Suppose you bet 𝑥. • Consumption if Arsenal lose: 𝑐2 = 1000 − 𝑥. • Consumption if Arsenal win: 𝑐1 = 1000 + 10𝑥. You think their probability is 𝑝1 .

• Expected (vNM) utility is 𝑝1 𝑢 𝑐1 + 1 − 𝑝1 𝑢 𝑐2 • You have a wealth of 𝑤 to spend on 𝑐1 and 𝑐2 together. • Asset 1 pays out 1 in state 1 and 0 in state 2 and costs 𝑞1 .Theoretical optimisation example (Certainly for next week) • Suppose that there are two possible future states of nature. with probabilities 𝑝1 and 1 − 𝑝1 respectively. ECO2051 – Intermediate Microeconomics . • And suppose that there are two risky assets you can purchase. 1 and 2. • Asset 2 pays out 1 in state 2 and 0 in state 1 and costs 𝑞2 .

Coming up next time • More concrete applications of expected utility theory • Insurance • Diversification in investment • Decisions over criminal actions • Application of expected utility theory to moral philosophy! ECO2051 – Intermediate Microeconomics .

Master your semester with Scribd & The New York Times

Special offer for students: Only $4.99/month.

Master your semester with Scribd & The New York Times

Cancel anytime.