ECON1268

Price Theory
Lecture 4 - Risk and Uncertainty
 Topics for today’s lecture . . .
1. Risky alternatives

2. Expected utility

3. Risk preferences

4. Insuring against risk

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Risky alternatives

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Discussion: Which job would you prefer? 1

• Imagine that you have just graduated from your degree.

You have two job offers to choose from:
o The first job with ‘Alpha Corp.’ has a salary of $50,000.

o The second job with ‘Beta Inc.’ has a salary of $30,000, and
pays you a bonus of $40,000 if you achieve your
performance targets. (You think that you have a 50%
probability of reaching these targets.)

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Discussion: Which job would you prefer? 2

• Which job would you choose?

• What factors would influence your decision?

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 Definition: Lottery
• Any choice (alternative) with uncertain consequences.

• In microeconomics we use lotteries to model uncertain

prospects such as investment returns

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 Describing a lottery 1
• The first step in describing a lottery is to list all of the
possible outcomes.

o Outcomes must be described such that they are mutually

exclusive.

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 Describing a lottery 2
• The second step is to determine the probability of each
outcome occurring.

o A probability is a number that lies between zero and one.

o The sum of the probabilities of all outcomes must be equal to

one.

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 Describing a lottery 3
• The third step is to determine the consequences of each
outcome for the decision-maker.

o We will typically consider situations in which the

consequences are monetary payoffs.

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Describing Alpha Corp.’s job offer as a lottery

• Outcome 1: You are

• 
employed.
o Probability = 1.

o You receive the salary =

$50,000.

• This is called a sure-thing

payoff because it occurs
with certainty.
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Describing Beta Inc.’s job offer as a lottery 2

• Outcome 1: You miss your targets.

•  
o Probability = 0.5.

o You receive the salary = $30,000.

• Outcome 2: You achieve your targets.

o Probability = 0.5.

o You receive the salary $30,000 and a bonus $40,000 (total =

$70,000)
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Describing Beta Inc.’s job offer as a lottery 1

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Comparing lotteries: Expected value 1

• An expected value can be calculated for any lottery that

gives rise to monetary payoffs. To calculate the expected
value, multiply each payoff by the probability it will occur,
and add them together.

o The expected value can be interpreted as the average

(mean) payoff the lottery would generate if repeated many
times.
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Comparing lotteries: Expected value 2

•  The expected value of the two job offers are:

o Alpha Corp.: = × = 1 × $50,000 = $50,000.

o Beta Inc.: = × + × = 0.5 × $30,000 + 0.5 × $70,000 =

$50,000.

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Comparing lotteries: Risk 1

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 Comparing lotteries: Risk 2
• Risk is a measure of the degree to which a lottery’s payoffs
are ‘spread out’.

o Both jobs have the same expected value.

o Beta Inc.’s job offer is more risky that Alpha Corp.’s job offer.

• It is common to measure a lottery’s risk using the variance

of its payoffs. 16
 Subjective probabilities 1
• In reality, the probabilities of events are rarely objectively
well defined.
o On the one hand, the probability of flipping ‘heads’ on a fair
coin is (close to) 0.5.
o On the other hand, it is hard to construct an objective
measure of the probability that there will be a recession next
year.

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 Subjective probabilities 2
• Subjective probabilities are a decision-maker’s
assessment of the risks she/he faces.
o Different decision-makers may hold different beliefs
concerning the probabilities of the outcomes of a risky event.
o So long as a decision-maker has (or behaves as though
she/he has) subjective probabilities, the results of today’s
lessons apply.

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Exercise: Describing an investment as a lottery 1

• Suppose that you purchase $10,000 of shares in

agricultural company that farms corn.

o There is a 50% probability of a good harvest, which will

increase the value of your shares by $4000.

o There is a 20% chance of a recession that will halve the

value of your shares.
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Exercise: Describing an investment as a lottery 1

• You should assume that the probabilities of the two events

are independent, and that (where applicable) the effects of
a recession are applied after the effects of a good harvest.

1. Describe this investment as a lottery, and illustrate the

lottery on a graph.

2. What is the expected value of this lottery?

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Expected utility

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Preferences over lottery outcomes 1
• A decision-maker’s preferences over outcomes will not
generally be sufficient to determine her/his preferences
over lotteries.
o The job offer from Alpha Corp. will allow you to purchase
50,000 units of the composite good.
o The job offer from Beta Inc. will allow you to either purchase
30,000 or 70,000 units of the composite good.

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Preferences over lottery outcomes 2

• If more-is-better with respect to the composite good

applies, then Beta Inc.’s job offer will produce either the
most-preferred, or least preferred, outcome.

• We need to add more structure to a decision-maker’s

preferences over lotteries if we are to understand decision-
making under uncertainty.
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 Definition: Independence axiom
• The axiom that states: A decision-maker’s preferences over
lotteries should depend only on the way in which two
lotteries differ.
• The independence axiom is a requirement of rationality in
the presence of uncertainty. The axiom is positive in the
sense that it describes an aspect of rationality; and
normative in the sense that your preferences must satisfy
the independence axiom in order to be rational.

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Discussion: Job offers with the threat of recession 1

• Consider the following variation on the job offers by Alpha

Corp. and Beta Inc.:

• Suppose that there is a 10% chance of a recession, in the

event of which you will lose your job and receive an income
of $0.

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Discussion: Job offers with the threat of recession 2

•   o Alpha Corp.’s job offer now gives you = $50,000 with

probability = 0.9, and = $0 with probability = 0.1.

o Beta Inc.’s job offer now gives you = $30,000 with probability
= 0.45, = $70,000 with probability = 0.45, and = $0 with
probability = 0.1.

• Which job offer would you choose?

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An example of the independence axiom at work

•  The independence axiom states that your choice of job

should be independent of whether or not there is a risk of
recession.

• Both lotteries deliver you a payoff = = $0 with probability

== 0.1. Because this feature is present in both lotteries, it
should not affect your choice.
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 Definition: Expected utility
• Expected utility: The sum of the utilities that a decision-
maker would derive from all possible outcomes of a lottery,
weighted by the probability that each outcome occurs.

• If a decision-maker’s preferences over lotteries satisfy the

independence axiom, then her/his preferences are
represented by expected utility
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The expected utilities of the job offers 1

•  Suppose that Harry’s preferences over income levels are

represented by the utility function U(I) = .

• Harry’s expected utility from Alpha Corp.’s job offer, which

delivers = $50,000 with probability = 1, is,

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 The expected utilities of the job offers 2

•  Harry’s expected utility from Beta Inc.’s job offer, which

delivers = $30,000 with probability = 0.5, and = $70,000
with probability = 0.5, is,

• Harry prefers the job with Alpha Corp.

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 Exercise: Expected utility
• Suppose that Harry’s preferences over income levels are
•  
represented by the utility function U(I) = .
1. Calculate the expected utility of Alpha Corp.’s job offer: =
$50,000 with = 0.9, and = $0 with = 0.1.
2. Calculate the expected utility of Beta Inc.’s job offer: =
$30,000 with = 0.45, = $70,000 with = 0.45, and IB3 =
$0 with pB3 = 0.1. 3.
• Which job will Harry choose?
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Risk preferences

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 Stock options or a bonus check 1
• Sally must choose between the following two bonus
schemes:

o Stock options that will be worth $1000 with probability p1 =

0.6, and $16,000 with probability p2 = 0.4.

o A (sure-thing) cash bonus of $7000.

• Note: Both alternatives have the same expected value.

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Stock options or a bonus check 2

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The utilities of the possible outcomes 1
• Sally’s preferences are represented by the utility function
•  
U(I) =
• The utilities associated with the possible outcomes are:
o U(1000) = 1.

o U(16,000) = 4.

o U(7000) ≈ 2.646.

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The utilities of the possible outcomes 2

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The expected utilities of the two alternatives 1

• The expected utility of the stock options is,

EU = 0.6 × 1 + 0.4 × 4 = 2.2.

• Note: For a two-outcome lottery, the expected utility is the
height of the line connecting the utilities of the two
outcomes, at the expected value.
• Sally is risk-averse because she prefers a sure-thing to a
lottery with the same expected value.

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The expected utilities of the two alternatives 2

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Risk aversion and diminishing marginal utility 1

• Sally’s utility function displays a diminishing marginal

utility; the function becomes flatter as income increases.

o Sally places increased weight on the downside, where the

marginal utility of income is high.

o Sally places reduced weight on the upside, where the

marginal utility of income is low.
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Risk aversion and diminishing marginal utility 2

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 Risk loving 1
• A decision-maker is risk-loving if she/he prefers a lottery
to a sure-thing with the same expected value.
• Risk-loving behaviour results from increasing marginal
utility.
o The weight on the downside is reduced, as the marginal
utility of income is low.
o The weight on the upside is increased, as the marginal utility
of income is high.
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Risk loving 2

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 Quiz 1
• Charlie’s utility function is U(I) = I /2000. He has to choose
between:

o A lottery paying $1000 with probability 0.6, and $16,000 with

probability 0.4.

o A sure-thing payoff of $7000.

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 Quiz 1 (cont.)
• From this information we can conclude that,

a) Charlie prefers the lottery over the sure-thing.

b) Charlie prefers the sure-thing over the lottery.

c) Charlie is indifferent between the two choices.

d) Charlie’s preferences cannot be deduced without a graph.

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 Risk neutrality 1
•  A decision-maker is risk-neutral if she/he is indifferent
between a lottery and a sure-thing with the same expected
value.

• Risk neutral decision-makers have linear utility functions,

U(I) = ,

• where is a constant, and is a positive constant.

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Risk neutrality 2

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When will a risk-averse decision-maker take a risk?
1

• Despite being risk-averse, Sally is willing to take a risk if

the potential reward is great enough.

• Suppose that instead of $7000, the cash bonus is $4000.

• Sally’s utility from the sure-thing payoff is now U(4000) = 2;

less than the expected utility of the stock options.

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When will a risk-averse decision-maker take a risk?
2

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 Risk premium 1
• A risk premium is the difference between the expected
value of a lottery, and the sure-thing payoff with the same
expected utility.
• For this lottery, Sally’s risk-premium is (approximately)
$2200.
• To find the risk premium of a lottery, solve the equation EU
= U(EV − RP) to find RP.

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Risk premium 2

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 Exercise: Risk premium
• Lola’s preferences over income levels are described by the
•  
utility function U(I) = 2 .
• Consider the lottery that delivers Lola = $2500 with
probability = 0.5, = $1600 with probability = 0.4, and =
$400 with probability = 0.1.
1. Find the expected value of this lottery.
2. Find Lola’s expected utility from this lottery.
3. Find Lola’s risk premium.
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Insuring against risk

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 The risk of an accident 1
•  Sena drives to work every day. Each year there is a 24%
probability that Sena will have a car accident, causing
$40,000 worth of damages.

o Sena’s income is $62,500.

o Sena’s utility function is U(I) = . Sena’s situation can be

described as a lottery:
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 The risk of an accident 2
•  = $62,500 with probability = 0.76.

• = $62,500 − $40,000 = $22,500 with probability = 0.24.

• The expected value is EV = 0.76 × 62,500 + 0.24 × 22,500

= $52,900

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 Insurance 1
• Sena has the option of purchasing an insurance policy that
will compensate him in the event of an accident.

o The insurance premium is a fee F, which Sena must pay

regardless of whether or not he has an accident.

o The policy pays Sena an amount $40,000 if he has an

accident.
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 Insurance 2
• The insurance policy provides Sena with a sure-thing (risk-
free) payoff:

• If Sena does not have an accident then his income will be I

= $62,500 − F.

• If Sena has an accident then I = $62,500 − $40,000 +

$40,000 − F = $62,500 − F.
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Definition: Fairly priced insurance policy
• An insurance policy in which the insurance premium is
equal to the expected value of the promised insurance
payment.
• A fairly priced insurance policy, which completely
compensates a decision-maker for losses they incur,
provides a sure-thing payoff equal to the expected value of
the lottery the decision-maker would face without
insurance.

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 Quiz 2
• A decision-maker would be willing to purchase a fairly
priced insurance policy, that completely compensates
her/him in the event that her/his house is damaged by a
flood, if the decision-maker is,

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 Quiz 2 (cont.)
a) risk-averse (but not risk-neutral or risk-loving).

b) risk-neutral (but not risk-averse or risk-loving).

c) risk-loving (but not risk-averse or risk-neutral).

d) either risk-averse or risk-neutral (but not risk-loving).

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The sure-thing payoff from fairly priced insurance

• The fair price for the insurance policy is the sum of any
payments the insurer may be required to make, weighted
by the probability that the payment will be required.
o For Sena’s insurance policy the fair price is 0.24 × $40, 000 =
$9600.

• The fair priced insurance policy provides Sena with the

sure-thing payoff I = 62,500 − 9600 = $52,900.
• This is exactly the expected value of the lottery Sena was
facing without insurance.
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 Sena’s preference for insurance
• Without insurance, Sena’s expected utility is,
•  

• With a fairly priced insurance policy, Sena’s utility is,

• Therefore, Sena prefers to purchase insurance. 61

The problems with fairly priced insurance policies 1

• The fair price of an insurance policy can be interpreted as

the average payment made by an insurance company, if it
insures many decision-makers with independently
distributed risks.

o The ‘fair price’ does not allow for an insurance company’s

cost of doing business.

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The problems with fairly priced insurance policies 2

o The ‘fair price’ does not allow the insurance company to build
the capital reserves necessary to fund payments in the event
of a correlated risk.

• For these reasons (and others) insurance premiums will

typically exceed the fair price.

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 Discussion: Moral hazard 1
• Suppose that you purchased a fairly priced insurance
policy for your car, which fully reimburses you for damage
suffered in an accident.

o How would the insurance policy affect the way you drive, and
the way you maintain your car?

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Discussion: Moral hazard 2
o What are the consequences of this change in behaviour for
the fair price of the policy?

o Would the problem remain if your insurance policy included a

deductible, requiring you to pay for part of the damage in the
event of an accident?

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Sena’s willingness-to-pay for insurance 1
• The maximum price Sena would be willing to pay for the
•  
insurance policy is the fair price ($9600) plus his risk
premium.
• To find Sena’s risk premium we need to solve the equation
EU = U(EV − RP).
• Substituting for Sena’s utility function, EV and EU, we get,

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Sena’s willingness-to-pay for insurance 2

• Squaring both sides of the equation,

51,076 = 52,900 − RP or RP = $1824.

• Thus the maximum price Sena is willing to pay is 9600 +

1824 = $11,424.

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Questions?

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Key concepts from today’s lecture 1
• You can use these concepts (as search terms) to conduct
further research into the topics covered in today’s lecture:
o Lottery

o Risk

o Expected value

o Independence axiom

o Expected utility
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Key concepts from today’s lecture 2
o Sure thing payoff

o Risk premium

o Insurance

o Fairly price insurance policy

o Deductible

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