Microeconomics

Session 18-19
 DESCRIBING RISK
probability Likelihood that a given outcome will occur.

expected value Probability-weighted average of the payoffs associated

with all possible outcomes.

payoff Value associated with a possible outcome.

expected utility Sum of the utilities associated with all possible

outcomes, weighted by the probability that each outcome will occur.
 MAKE A CHOICE
• 1> Rupees 10,000 (Ten Thousand)
• 2> A lottery ticket to fetch Rupees
1,000,000 (Ten Lakh) with probability
1/100.

• Do you prefer
– 1 over 2
– 2 over 1
– Indifferent between 1 and 2
 Expected Value of a Lottery
• This lottery has two outcomes
– Rs 0 with probability 0.99
– Rs 10,00,000 with probability 0.01

• Expected value = x1 ·P(x1) + x2 ·P(x2)

= 0 × 0.99 + 10,00,000 × 0.01
= Rs 10,000
 Think about it!
• Those who prefer 1 over 2 may prefer Rs.
8,000 as much as the lottery 2.
• Then the certainty equivalent of gamble 2
is Rs. 8,000 lakh.
• The risk premium is expected value of the
gamble – certainty equivalent = Rs. 10,000
– Rs. 8,000 = Rs. 2,000.
 EXPECTED UTILITY OF MONEY

Utility Risk premium

U(High)

EU (lottery)

U(low)

Low CE E(lottery) High

Prize
RISK AVERSION
• The certainty equivalent of a monetary gamble g is an
amount CE(g) such that the consumer is indifferent
between accepting the gamble or accepting CE(g) with
certainty.
• If E(g) is the expected payoff from a gamble the
risk premium associated with that gamble is:
E(g) − CE(g)
• risk premium Maximum amount of money that a risk-
averse person will pay to avoid taking a risk.
• A consumer is
Risk averse: if CE(g) < E(g)
Risk neutral: if CE(g) = E(g)
Risk lover: if CE(g) > E(g)
 PREFERENCES TOWARD RISK
Figure 5.3
Risk Averse, Risk Loving, and
Risk Neutral (continued)

In (b), the consumer is risk

loving:

She would prefer the

gamble to the certain
income.

Finally, the consumer in (c)

is risk neutral,
and indifferent between
certain and uncertain
events with the same
expected income.
 Problem
• Find certainty equivalent and risk premium
for these utility functions:
– U(x) = x2
– U(x) = √x
– U(x) = x
 REDUCING RISK
● diversification Practice of reducing risk by allocating resources to a
variety of activities whose outcomes are not closely related.

TABLE 5.5 Income from Sales of Appliances ($)

Hot Weather Cold Weather

Air conditioner sales 30,000 12,000
Heater sales 12,000 30,000

● negatively correlated variables Variables having a tendency to move in

opposite directions.

● mutual fund Organization that pools funds of individual investors to buy a

large number of different stocks or other financial assets.

● positively correlated variables Variables having a tendency to move in

the same direction. For example, a recession will cause stock prices to
move in the same direction.
 REDUCING RISK
Insurance
TABLE 5.6 The Decision to Insure ($)
Burglary No Burglary Expected Standard
Insurance (Pr = .1) (Pr = .9) Wealth Deviation
No 40,000 50,000 49,000 3000
Yes 49,000 49,000 49,000 0

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.

Actuarial Fairness
● actuarially fair Characterizing a situation in which an insurance premium
is equal to the expected payout.
 Homework
• Page 212, Chapter 5, Exercise 3
• Page 212, Chapter 5, Exercise 5
• Page 212, Chapter 5, Exercise 6
• Page 213, Chapter 5, Exercise 7