MOSTAFA NOR-EL DIN Information Economics BIS Level (4) 2

Chapter Two
Uncertainty and Information

Decisions in the face of Uncertainty

Nahla, a student, is trying to decide which of two alternative summer jobs to take.

1) she can work as a house painter and
have $2,000 in at the end of the summer
and there is no uncertainty about the
income from this job.
2) the other job is working as a
telemarketer. Nahla thinks that there is a
50 percent chance that she will earn $5,000
and a 50 percent chance that she will earn
$1,000.

Which job does she prefer?

Expected Wealth (EW)

Is the money value of what a person expects to own at a given point in time.

Expected Value (EV)

Is the value of each possible outcome times the probability of that outcome.

What is Nahla’s expected The probability that Nahla will have $5,000 is 0.5
wealth from the
telemarketing job?
The probability that she will have $1,000 is also 0.5

Expected wealth = ($5,000 × 0.5) + ($1,000 × 0.5) = $3,000

Nahla can now compare the expected wealth from two jobs:
$2,000 from non-risky painting job
$3,000 for the risky telemarketing job.

Will Nahla take the risky job? It will depend on how much Nahla dislike risk.

Risk Aversion

 Is the dislike of risk

 We measure a person’s attitude toward risk by using a utility of wealth schedule and
curve.
 Greater wealth brings greater total utility, but the marginal utility of wealth
diminishes as wealth increases.
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Utility of wealth

Figure 20.1 shows that as Nahla’s utility of wealth

curve.
 If Nahla’s wealth is $2,000 she gets 70 units of
utility.
Nahla’s total utility increases when her wealth
increases.
But
 the marginal utility of wealth diminishes.

 Each additional $1,000 of wealth brings

successively smaller increments in total utility.

Because of diminishing marginal utility,

For a loss of wealth or a gain of wealth equal size, Nahla’s pain from the loss exceeds her pleasure
from the gain.

Expected utility

 When there is uncertainty, people do not know the actual utility they will get from taking a
particular action.
 But they know the utility they expect to get.
 Expected utility: Is the utility value of what a person expects to own at a given point of time.

Figure 20.2 shows how Nahla calculates her

expected utility.

 Nahla has a 50 percent chance of having

$5,000 of wealth and total utility of 95 units.
 Nahla has a 50 percent chance of having
$1,000 of wealth and total utility of 45 units.
 Nahla’s expected wealth is $3,000 and her
expected utility is 70 units.
 With $3,000 wealth and no uncertainty, utility
is 83 units.

For a given expected wealth, the greater the range of uncertainty, the smaller is expected utility.
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Making choice with Uncertainty

Faced with uncertainty, a person choose the action that maximizes expected utility.

To select the job that gives her the maximum expected utility, Nahla must calculate:

1) the expected utility from the risky telemarketing job.

2) the expected utility from the safe painting job.
3) compare the two expected utility.

Figure 20.3 shows the choice under uncertainty.

In a telemarketing job there is a 50 percent

chance that Nahla will make $5,000 and a 50
percent chance that she will make $1,000.

Her expected wealth is $3,000 and her expected

utility is 70 units.
Nahla would have the same 70 units utility with
wealth of $2,000 and no risk, so………..
Nahla’s cost of bearing this risk is $1,000.

Nahla is indifferent between the job that pays $2,000 with no risk and the job that offers equal
chance of $5,000 and $1,000.