Uncertainty is Pervasive

What may be uncertain in an

economy?

– future prices
– future availability of commodities
– present and future actions of other
people
 Uncertainty is Pervasive
What are rational responses to
uncertainty?

– buying insurance
(e.g., health, life, auto, …)

– a portfolio of contingent
consumption goods
States of Nature (SON)

Example: possible SONs:

– car accident (a)
– no accident (na)

Accident occurs with probability a,

does not with probability na :
a + na = 1
 Contingencies

State-contingent contracts:
contracts implemented only when
a particular SON occurs.

E.g.: the insurer pays only if there

is an accident.
 Contingencies

A state-contingent consumption
plan is implemented only when a
particular SON occurs.

E.g.: take a vacation only if there is

no accident.
State-Contingent Budget Constraints

Each $1 of accident insurance costs 

Consumer has wealth: $m
Accident loss: $L
Cna is consumption value in the no-
accident state.
Ca is consumption value in the
accident state.
State-Contingent Budget Constraints
Cna A state-contingent consumption
with $17 consumption in state a
and $20 consumption in state na.

Endowment Without insurance:

m=20
Ca = m – L
Cna = m

Ca
m-L=17
Comparison with Intertemporal Choice

1. Across-period v. Same-period

2. Borrow/save (2-way) v. Insure (1-way)

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State-Contingent Budget Constraints

With $K of accident insurance:

Cna = m - K

Ca = m - K – L + K
= m - L + (1- )K
State-Contingent Budget Constraints

With $K of accident insurance:

From Ca = m - L + (1- )K

we have: K = (Ca - m + L)/(1- )
Substituting K into Cna:
Cna = m -  (Ca - m + L)/(1- )
Therefore:
m − L 
Cna = − Ca
1− 1−
State-Contingent Budget Constraints
Cna
m − L 
C na = − Ca
1− 1−
Endowment
m


slope = −
1−

Ca
m−L m − L

Preferences Under Uncertainty

Think of a lottery:

1. Win $90 with p=1/2 => U($90)=12

2. Win $0 with p=1/2 => U($0) = 2

Preferences Under Uncertainty

Expected money value (期望幣值):

1 1
EM =  $90 +  $0 = $ 45.
2 2
Preferences Under Uncertainty

Expected utility (期望效用):

1 1
EU =  U($90) +  U($0)
2 2
1 1
=  12 +  2 = 7.
2 2
Preferences Under Uncertainty

12

EU=7

2
Wealth
$0 $45 $90
(EM)
Preferences Under Uncertainty
The lottery: EM = $45 and EU = 7
> Compare: U(EM) v. EU

U($45) > 7  $45 for sure is preferred

to the lottery  risk-averse
U($45) < 7  the lottery is preferred
to $45 for sure  risk-loving
U($45) = 7  the lottery is preferred
equally to $45 for sure  risk-neutral
 Preferences Under Uncertainty
U(EM) > EU  risk-averse

12 MUI (slope) declines

U(EM) as wealth rises.

EU=7

2
Wealth
$0 $45 $90
(EM)
 Preferences Under Uncertainty
U(EM) < EU  risk-loving

12
MUI (slope) rises
as wealth rises.
EU=7

U(EM)
2
Wealth
$0 $45 $90
(EM)
 Preferences Under Uncertainty
U(EM) = EU  risk-neutral

12 MUI constant as
wealth rises.
U(EM)=
EU=7

2
Wealth
$0 $45 $90
(EM)
Preferences Under Uncertainty

State-contingent consumption plans

(lotteries) that give equal expected
utility (EU) are equally preferred.
Preferences Under Uncertainty

Cna
Indifference curves
EU1 < EU2 < EU3

EU3
EU2
EU1
Ca
Preferences Under Uncertainty
What is the MRS of an indifference
curve?
Get consumption c1 with prob. 1 and
c2 with prob. 2 (1 + 2 = 1)
EU = 1U(c1) + 2U(c2)
For constant EU: total differentiation
dEU = 0
 Preferences Under Uncertainty
E U =  1 U (c 1 ) +  2 U (c 2 )
d E U =  1 M U (c 1 )d c 1 +  2 M U (c 2 )d c 2

d E U = 0   1 M U (c 1 )d c 1 +  2 M U (c 2 )d c 2 = 0

  1 M U (c 1 )d c 1 = −  2 M U (c 2 )d c 2

dc 2  1MU(c1 )
 =− .
dc1  2MU(c 2 )
 Preferences Under Uncertainty

Cna
dc na  a MU(c a )
=−
dc a  na MU(c na )

EU3
EU2
EU1
Ca
 Choice Under Uncertainty

[Q] How is a rational choice made

under uncertainty?

[A] Choose the most preferred

affordable state-contingent
consumption plan.
State-Contingent Budget Constraints

Cna m − L 
C na = − Ca
1− 1−
endowment
m
Where is the
 most preferred
slope = −
1− state-contingent
Affordable
plans consumption plan?

Ca
m−L m − L

 State-Contingent Budget Constraints
Cna

More preferred
m

Ca
m−L m − L

State-Contingent Budget Constraints

Cna
Most preferred affordable plan
m

Ca
m−L m − L

State-Contingent Budget Constraints

Cna
Slope of budget line = MRS
m
  a MU(c a )
=
1 −   na MU(c na )

Ca
m−L m − L

Competitive Insurance Market
Assume competitive insurance
market: zero expected profit
K - aK = ( - a)K = 0

  = a

Insurance is actuarially fair:

price of $1 insurance
= accident probability
 Competitive Insurance
When insurance is fair, rational
insurance choices satisfy:
 a  a MU(c a )
= =
1 −  1 −  a  na MU(c na )
I.e.:
M U (c a ) = M U (c n a )
Marginal utility of income (MUI) must
be the equal in both states.
 Competitive Insurance

How much fair insurance does a risk-

averse consumer buy?
M U (c a ) = M U (c n a )
Risk-aversion  MU(c)  as c 
Hence:
c a = c na .
I.e., full-insurance
 Unfair Insurance
What if insurers make positive
expected economic profit?

I.e. K - aK = ( - a)K > 0

Then   > a   a
 .
1− 1−a
 Unfair Insurance
Rational choice requires
  a MU(c a )
=
1 −   na MU(c na )
Since  a
 , M U (c a ) > M U (c n a )
1− 1−a
Hence c a < c na for a risk-averter.
I.e. a risk-averter buys less than full
unfair insurance.
 Uncertainty is Pervasive
What are rational responses to
uncertainty?

✓ – buying insurance (health, life, auto)

? – a portfolio of contingent
consumption goods [Franco
Modigliani (Nobel 1985, 1918-2003)]
 Diversification
Two firms: A and B
Shares cost $10.
With probability p=½
=> A’s profit is $100; B’s profit is $20
With probability p=½
=> A’s profit is $20; B’s profit is $100

You have $100. How to invest?

 Diversification
Plan A: Buy only firm A’s stock
$100/10 = 10 shares.
You earn:
$1000 with p=1/2
$200 with p=1/2.
Expected earning:
$500 + $100 = $600
 Diversification
Plan B: Buy only firm B’s stock
$100/10 = 10 shares.
You earn:
$1000 with p=1/2
$200 with p=1/2.
Expected earning:
$500 + $100 = $600
 Diversification
How about buying 5 shares in each
firm?
=> You earn $600 for sure.

Diversification:
- Maintained expected earning
- Lowered risk
- Franco Modigliani (MIT, Nobel 1985)
 Diversification

But typically, diversification lowers

expected earnings in exchange for
lowered risk.

高風險，高報酬； 低風險，低報酬
 Risk Spreading
1000 risk-neutral persons, all with
initial wealth $40K
Each independently faces a risk of
$10K loss with probability = 1%
On average, there will be 10 losses
and $100K lost each year.
Individual expected loss L = $100/yr
► expected annual wealth:
 Mutual Insurance
Insuring each other: if anyone incurs a
loss of $10K, each of the 1000 people has
to contribute $10 to him.
► Individual expected payment per year:
P = $10x10 = $100 = L
► Fully insured against the $10K loss!
Saving for disasters: each save $100 for
certain to a fund, used in future for losses.
► On average, all risks are removed.

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