Optimization in Economic Theory

PD Dr. Johannes Paha

University of Hohenheim

winter term 2021/22

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 Chapter 9 – Decision Making Under Uncertainty

Chapter 9
Decision Making Under Uncertainty

Jan 12, 2022

Optimization in Economic Theory

PD Dr. Johannes Paha
winter term 2021/22

johannes.paha@uni-hohenheim.de Optimization in Economic Theory (winter term 2021/22) 2 / 27

 Chapter 9 – Decision Making Under Uncertainty Double click here for audio contents

Organization – Schedule (Lecture)

Tue, Oct 19, Chapter 1.1 – Introduction and Linear Algebra
Wed, Oct 20, Chapter 1.2 – Solving Linear Systems
Wed, Oct 27, Chapter 1.3 – Matrix Algebra
Wed, Nov 03, Chapter 2 – Derivatives and Differentials
Wed, Nov 10, Chapter 3 – Derivatives: Further Insights
Wed, Nov 17, Chapter 4 – Derivatives: Concavity and Convexity
Wed, Nov 24, Chapter 5 – Constrained Optimization I
Wed, Dec 01, Chapter 6 – Constrained Optimization II
Wed, Dec 08, Chapter 7 – Constrained Optimization III
Tue, Dec 14, Chapters 7 and 8
Wed, Dec 22, Chapter 8 – Lagrange Multiplier & Envelope Theorem
Wed, Jan 12, Chapter 9 – Decision Making Under Uncertainty
Wed, Jan 19, Chapter 10 – Dynamic Programming I
Wed, Jan 26, Chapter 10 – Dynamic Programming II
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 Chapter 9 – Decision Making Under Uncertainty

Organization – Schedule (Tutorial)

Tue, Oct 19, Lecture
Tue, Oct 26, Assignment 1, Mathematical Basics
Tue, Nov 02, Assignment 2, Linear Systems
Tue, Nov 09, Assignment 3, Matrix Algebra
Tue, Nov 16, Assignment 4, Derivatives I
Tue, Nov 23, Assignment 5, Derivatives II
Tue, Nov 30, Assignment 6, Derivatives III
Tue, Dec 07, Assignment 7, Constrained Optimization I
Tue, Dec 14, Assignment 8, Constrained Optimization II
Tue, Dec 21, Assignment 9, Constrained Optimization IIIa
Tue, Jan 11, Assignment 10, Constrained Optimization IIIb
Tue, Jan 18, Assignment 11, Lagrange Multiplier and Envelope Theorem I
Tue, Jan 25, Assignment 12, Lagrange Multiplier and Envelope Theorem II
Tue, Feb 01, Assignment 13, Uncertainty & Dynamic Programming
Wed, Feb 02, Recap
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 Chapter 9 – Decision Making Under Uncertainty Double click here for audio contents

Overview – Decision making under uncertainty

Motivation
Preliminaries
Example: Optimal insurance
Example: Moral hazard
Continuum of states
Example: Safe versus risky asset
Concluding remarks

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 Chapter 9 – Decision Making Under Uncertainty Double click here for audio contents

Learning goals

Students
Can explain the concepts of expected utility,
von Neumann-Morgenstern utility, risk aversion, full insurance, asymmetric
information, and moral hazard.
Can solve problems with a discrete number of states where the choice variables
affect the outcomes (as in the optimal insurance example).
Can solve problems with a discrete number of states where the choice variables
affect the outcomes and probabilities (as in the moral hazard example).
Can solve problems with a continuum of states where the choice variables affect
the outcomes (as in the safe versus risky asset example).

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 Chapter 9 – Decision Making Under Uncertainty Double click here for audio contents

Motivation

So far, we have supposed that the consequences of choices are certain

Consumption of x units leads to utility u(x ).
Selling y units gives rise to revenues of p · y .
In the real world, however, the outcomes are often uncertain.
By uncertainty we mean that we know the potential outcomes in advance, and we
may even know the probabilities with which these outcomes occur in advance.
This type of uncertainty can also be called risk in order to distinguish it from
genuine uncertainty where the possible outcomes are not known in advance, let
alone the probabilities with which they occur.
How can we solve optimization problems in the context of uncertain (or risky)
outcomes?

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 Chapter 9 – Decision Making Under Uncertainty Double click here for audio contents

Motivation

The presence of risk (uncertainty) does not require new mathematical theory.
The choices now lead to random outcomes with subjective or objective probability
distributions.
The objective function therefore contains probability-weighted averages.
In other words, we maximize expected values and draw on tools from expected
utility theory.

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 Chapter 9 – Decision Making Under Uncertainty Double click here for audio contents

Preliminaries – A discrete number of states

After the decision has been taken, the world can evolve in a number of different
ways.
These are called states or elementary events.
Suppose that states are discrete, finite,
and indexed by i = 1, 2, . . . , m.
The (subjective or objective) probability of each state is non-negative: pi ≥ 0 for
all i
P
Probabilities add up to unity: i
pi = 1.
The economically relevant outcomes are denoted by Yi . These are often scalars
but a generalization to vectors can be made.
The general objective function can be written as

F (Y1 , Y2 , . . . , Ym , p1 , p2 , . . . , pm ).

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 Chapter 9 – Decision Making Under Uncertainty Double click here for audio contents

Preliminaries – Expected utility

The choice or control variable x affects some or all of the Yi and pi .

The control variables might be subject to additional constraints.
Under specific restrictions on the preferences, the objective function can be written
as the mathematical expectation of the outcomes in different states
m
X
pi · U(Yi ).
i=1

The function U(Yi ) is called von Neumann-Morgenstern utility function.

The whole expression is called expected utility.

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 Chapter 9 – Decision Making Under Uncertainty Double click here for audio contents

Preliminaries – Risk aversion and strict concavity

Suppose there are two two states with distinct outcomes Y1 and Y2 with different
positive probabilities p and 1 − p.
Compare this to the certain alternative Y = [pY1 + (1 − p)Y2 ], which is the
expected value and is actuarially equivalent.
For example: Lottery ticket with a 50% chance to win 100 Euro and a 50% chance
to win nothing versus the certain payment of 50 Euro.
A decision-maker who is risk averse prefers the certain outcome, i.e.
U[pY1 + (1 − p)Y2 ] > pU(Y1 ) + (1 − p)U(Y2 ).
According to our definition, this implies that U(Yi ) is strictly concave in the range
[Y1 , Y2 ].

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 Chapter 9 – Decision Making Under Uncertainty Double click here for audio contents

Preliminaries – Shape of the utility fn and risk perceptions

More generally, strict concavity implies

m
! m
X X
U pi Yi > pi · U(Yi ).
i=1 i=1

If U is twice differentiable, U ′′ (Yi ) < 0 corresponds to risk-aversion.

Strict convexity implies “<” instead of “>”,
which corresponds to risk loving.
A linear utility function implies “=” instead of “>”,
which corresponds to risk neutrality.

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 Chapter 9 – Decision Making Under Uncertainty Double click here for audio contents

Preliminaries – Measures of risk aversion

Absolute risk aversion

U ′′ (Yi )
ARA(Yi ) = −
U ′ (Yi )
Relative risk aversion
Yi U ′′ (Yi )
RRA(Yi ) = −
U ′ (Yi )

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 Chapter 9 – Decision Making Under Uncertainty Double click here for audio contents

Preliminaries – Special classes of utility functions

Constant relative risk aversion (CRRA),

RRA(Yi ) is constant
Example: U(Yi ) = ln(Yi ) with RRA= 1
Example: U(Yi ) = Yiα , α ∈ (0, 1) with RRA= 1 − α
Constant absolute risk aversion (CARA)
ARA(Yi ) is constant
Example: U(Yi ) = 1 − e −aYI , a > 0 with ARA= a
Hyperbolic absolute risk aversion (HARA),
The inverse of ARA is a linear function of Yi
Requires the form
 γ
1−γ aYI aYI
U(Yi ) = +b , a > 0, b + >0
γ 1−γ 1−γ

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 Chapter 9 – Decision Making Under Uncertainty Double click here for audio contents

Example: Optimal insurance – Setting

Consider a situation with two outcomes Y1 and Y2 , where state 1 is realized with
probability p and state 2 with probability 1 − p.
Suppose Y1 < Y2 such that there is a loss in state 1 as compared to state 2 (good
1 is the bad state, good 2 is the good state).
Further suppose that insurance is available: 1 Euro of insurance premium paid
yields b Euros of compensation if state 1 occurs.
After paying x units of the premium, the outcomes change to Y1 − x + bx in state
1 and to Y2 − x in state 2 (note that the insurance premium is paid in advance
and therefore affects outcomes in both states)
The objective function is
F = p · U(Y1 − x + b · x ) + (1 − p) · U(Y2 − x )

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Example: Optimal insurance – First order condition

Recall the objective function

F = p · U(Y1 − x + b · x ) + (1 − p) · U(Y2 − x )
The first order condition (FOC) for x to be an optimum is
pU ′ (Y1 − x + bx )(b − 1) − (1 − p)U ′ (Y2 − x ) = 0.
Insurance firms pool many such idiosyncratic risks.
In a competitive market, insurance firms have zero expected profits: 1 = p · b (for
each Euro they receive, they have to pay out b Euros with probability p).
In this case, the insurance is said to be actuarially fair.
Using (1 = bp) in the FOC, we get
U ′ (Y1 − x + bx ) = U ′ (Y2 − x ).

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Example: Optimal insurance – Full insurance

Recall, with an actuarially fair insurance, the optimal choice of x yields the FOC
U ′ (Y1 − x + bx ) = U ′ (Y2 − x ).
In case of U ′′ < 0 this is also sufficient.
Hence, x is chosen such that
Y1 − x + bx = Y2 − x ,
which means that households are willing to buy actuarially fair insurance up to the
point, where the outcomes of the two states are equal.
This is called full insurance or full hedging.

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Example: Moral hazard – Setting

Consider again a situation with two states,

a bad one Y1 and a good one Y2 .
Suppose now that the probability of the bad state can be reduced
by incurring the expense z for “care”.
This might be to buy a more expensive but more secure product
(e.g., an alarm system to protect against theft, a fire sprinkling system, etc.).
Now, p is a decreasing function of z.
Since p is bounded from below, it is generally convex.
Suppose that for the moment no insurance is available.
The objective function is
ϕ(z) ≡ p(z)U(Y1 − z) + [1 − p(z)]U(Y2 − z).

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Example: Moral hazard – First order condition

The FOC of the optimal choice of care z is

ϕ′ (z) = −p ′ (z)[U(Y2 − z) − U(Y1 − z)]
− p(z)U ′ (Y1 − z) + [1 − p(z)]U ′ (Y2 − z) .

(1)
The first line of the RHS is the expected marginal benefit of care (note that
p ′ (z) < 0 and the term is positive).
It is the product of the marginal reduction in the probability of the bad outcome
and the difference in utility between the two outcomes.
The second line is the expected marginal cost of care (note that U ′ (·) > 0 and the
term is negative).
For the optimal level of care, benefits and costs are equal such that ϕ′ (z) = 0.

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Example: Moral hazard – Insurance and care

Now suppose that both insurance and care are available.

Moreover, suppose that the insurance company cannot observe z and therefore
cannot condition the contract upon it.
Each insured person chooses x and z so as to maximize
ϕ(x , z) ≡ p(z)U(Y1 − z − x + bx ) + [1 − p(z)]U(Y2 − z − x ).
For the optimal choice of x , we have ϕx (x , z) = 0 or
p(z)U ′ (Y1 − z − x + bx )(b − 1) − [1 − p(z)]U ′ (Y2 − z − x ) = 0.
Again, in a competitive market we have b · p(z) = 1 and therefore full hedging:
Y1 − z − x + bx = Y2 − z − x .

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Example: Moral hazard – First order conditions

Recall that the optimal choice of x implies that the outcomes in the two
states are equalized.
Call this common value Y0 .
When x is chosen optimally, the FOC related to the optimal choice z
emerges in analogy to (1) as
ϕz (x , z) = −p ′ (z)[U(Y2 − z − x ) − U(Y1 − z − x + bx )]
− {p(z)U ′ (Y1 − z − x + bx ) + [1 − p(z)]U ′ (Y2 − z − x )}
= −p ′ (z)[U(Y0 ) − U(Y0 )] − U ′ (Y0 ) = −U ′ (Y0 ) < 0,
The marginal benefit from care vanishes (as there is insurance),
but the marginal cost stays positive.
This implies that optimal choice for care runs into its corner solution z = 0.
The availability of insurance destroys the incentives for “care”.
Rational individuals will not invest in care anymore.
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Example: Moral hazard

This is what is called moral hazard.

Moral hazard arises due to the presence of asymmetric information
One party (the agent) has information about care
The other party (the insurance firm) does not have information on care
(and can therefore not condition the contract on care)
In practice, in case of moral hazard only partial insurance is available.
In this case, perfectly competitive markets do not necessarily lead to efficient
outcomes (i.e., asymmetric information constitutes a market imperfection)

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Continuum of states

Suppose now that we have a continuum rather than a discrete number of states
We replace the index i by a random variable r defined over an interval [r, r̄ ] and
the probabilities pi by a density function f (r ).
Expected utility is Z r̄
E [U(Y )] = U[Y (r )]f (r )dr .
r
The interpretation of risk-aversion parallels the discrete case.
The mathematical expectation of Y is
Z r̄
E [Y ] = Y (r )f (r )dr .
r

Then U ′′ < 0 implies U(E [Y ]) > E [U(Y )], which is an application of Jensen’s
inequality.

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Example: Safe versus risky asset – Setting

Consider an investor with initial wealth W0 .

Investing x in the risky asset yields x (1 + r ),
where r is a random variable with density f (r ).
The safe asset pays zero interest.
Final wealth is random and amounts to
W = (W0 − x ) + x (1 + r ) = W0 + xr .
We assume that x is in the range [0, W0 ] such that short sales and borrowing at
the riskless rate are not allowed.
The investor has a strictly concave von Neumann-Morgenstern utility function U
and chooses x so as to maximize Z
r̄
E [U(W )] = U(W0 + xr )f (r )dr .
r

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Example: Safe versus risky asset – First order condition

Let ϕ(x ) denote the expected utility as a function of x such that the FOC of the
optimal investment decision problem is
Z r̄
ϕ′ (x ) = rU ′ (W0 + xr )f (r )dr = 0.
r
In particular, if x = 0, we have
Z r̄
ϕ′ (0) = U ′ (W0 ) rf (r )dr = U ′ (W0 )E [r ].
r
For a positive expected r , we cannot have x = 0 and also the risk-averse investor
will want to buy some of the actuarially profitable investment.
If r > 0, then ϕ′ (x ) > 0 for all x and we run into the corner solution where it is
optimal to invest the whole W0 in the risky asset.

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Example: Safe versus risky asset – Diversification

In general, there will be some

Z r̄ diversification (both investment in the safe and the
risky asset) such that the FOC with respect to x is fulfilled:
rU ′ (W0 + xr )f (r )dr = 0.
r
If an x < W0 fulfills this, then the concavity of the utility function guarantees that
this is the global optimum.
Various generalizations exist:
Many different assets with different mean returns and different
variances.
Typically the risk-free asset also delivers positive (albeit smaller)
returns.
The more risk-averse individuals are, the smaller is the proportion of risky assets
they should hold.
There is always a trade-off between return and risk!

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Concluding remarks

We have introduced risky outcomes into the analysis

We have explored cases with discrete stages where choice variables affect
Outcomes (optimal insurance example)
Probalities (first part of the moral hazard example)
Or both (second part of the moral hazard example)
And a case with a continuum of stages where the choice variable affects outcomes
We have seen that a risk-averse agent fully insures (or hedges) against risk, but
that full insurance is only available in the absence of asymmetric information

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