Chapter 15

Risk and Information

Chapter Fifteen Overview
• Describing Risky Outcomes
• Evaluating Risky Outcomes
• Bearing and Eliminating Risk
• Analyzing Risky Decisions

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• Auctions

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Tools for Describing Risky Outcomes
• A lottery is any event with an uncertain outcome
– Examples: investment, roulette, football game
• A probability of an outcome (of a lottery) is the likelihood
that this outcome occurs
– The probability may be estimated by the historical frequency of

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the outcome.

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Probability Distribution
• The probability distribution of the lottery depicts all possible
payoffs in the lottery and their associated probabilities
• Axioms:
– The probability of any particular outcome is between 0 and 1
– The probability of a certain event is 1.

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– The sum of the probabilities of all possible outcomes equals 1
• Probabilities that reflect subjective beliefs about risky
events are called subjective probabilities
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Probability Distribution of a Lottery
• The probability of outcome A
(values goes up to $120) is
0.30
• The probability of outcome B
(value remains at $100) is 0.40
• The probability of outcome C

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(value drops to $80) is 0.30
• Note that probabilities sum to
1.00

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Expected Value
• The expected value of a
lottery is a measure of the
average payoff that the lottery
will generate.
• EV = Pr(A)xA + Pr(B)xB +
Pr(C)xC
– Where: Pr(.) is the probability of
(.) A,B, and C are the payoffs if
outcome A, B or C occurs
• In our example lottery, which
pays $25 with probability .67
and $100 with probability 0.33,
the expected value is:
• EV = .67 x $25 + .33 x 100 =
$50
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• Notice that the expected value
need not be one of the
outcomes of the lottery
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Variance and Standard Deviation
• The variance of a lottery is the sum of the probability-
weighted squared deviations between the possible outcomes
of the lottery and the expected value of the lottery
– It is a measure of the lottery's riskiness.
• Var = (A - EV)2(Pr(A)) + (B - EV)2(Pr(B)) + (C - EV)2(Pr(C))

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• The standard deviation of a lottery is the square root of the
variance
– It is an alternative measure of risk

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Variance and Standard Deviation for the Lottery
Example
• The squared deviation of winning is ($100 - $50)2 = 502 =
2,500
• The squared deviation of losing is ($25 - $50)2 = 252 =
625
• The variance is (2,500 x .33)+ (625 x .67) = 1,250

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• The standard deviation is

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Evaluating Risky Outcomes
• Will make $54,000 per year at company A
• Will make $4,000 at startup company B
– Bonus of $100,000 if firm becomes profitable this year
– This has a 0.50 probability

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• Expected value at A is
• Expected value at B is

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Utility Function with Diminishing Marginal Utility

• When income is low ($4,000),

utility increases by the
distance from point Q to point
R
• When income is high
($104,000), utility increases by

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the distance from point S to
point T

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Utility Function and Expected Utility
• Your utility if you take the job with
company A will be 230 (point B)
• If you take the job with company B,
there is a 0.50 probability that your
utility will be 320 (point C, if you
earn $104,000)
• And a 0.50 probability that your

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utility will be 60 (point A, if you earn
$4,000)
• This yields an expected utility of
190 (point D)
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Risk Preferences
• An individual who prefers a sure thing to a lottery with the
same expected value is risk averse
• An individual who is indifferent about a sure thing or a
lottery with the same expected value is risk neutral
• An individual who prefers a lottery to a sure thing that

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equals the expected value of the lottery is risk loving (or
risk preferring)

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Risk Preferences Example
• Suppose that an individual
must decide between buying
the stock of an internet firm
and the stock of a public utility
• The values that the shares of
the stock may take (and,

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hence, the income from the
stock, I) and the associated
probability of the stock taking
each value are shown at right
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Risk Preferences Example Continued
• Which stock should the individual buy if she has a utility function
?
• Which stock should she buy if she has utility function U = I?
• EU(Internet) = .3U(80) + .4U(100) + .3U(120)
• EU(P.U.) = .1U(80) + .8U(100) + .1U(120)

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• a. U :
– U(80) = = 89.40
– U(100) = = 100
– U(120) = = 109.5
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Risk Preferences Example Continued
• EU(Internet) = .3(89.40)+.4(100)+.3(109.50) = 99.70
• EU(P.U.) = .1(89.40) + .8(100) + .1(109.50) = 99.9
• The individual should purchase the public utility stock
• U = I:

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• EU(Internet) = .3(80)+.4(100)+.3(120)=100
• EU(P.U.) = .1(80) + .8(100) + .3(120) = 100
• This individual is indifferent between the two stocks
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Utility Function – Risk-Averse Decision Maker

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16
Utility Function – Risk-Averse Decision Maker

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Utility Function – Risk-Averse Decision Maker

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Utility Function – Risk-Averse Decision Maker

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Utility Function – Two Risk Approaches: Risk
Neutral (Left) and Risk-Loving (Right)

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The Risk Premium for a Risk-Averse Decision
Maker
• If the salary offer from the
established company were
$37,000 per year, you would
be indifferent between the
offers
• The two offers would have the

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same utility (190)
• The risk premium is given by
the length of line segment ED,
which equals $17,000
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Risk Premium
• The risk premium of a lottery is the necessary difference
between the expected value of a lottery and the sure thing
so that the decision maker is indifferent between the
lottery and the sure thing
• pU(I1) + (1-p)U(I2) = U(pI1 + (1-p)I2 - RP)

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• The larger the variance of the lottery, the larger the risk
premium

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Computing a Risk Premium
• p = .5
• I1 = $104,000
• I2 = $4,000
• Verify that the risk premium for this lottery is approximately $17,000
• .5 + .5 =

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• $192.87 =
• $37,198 = $54,000 - RP
• RP = $16,802
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Computing a Risk Premium Continued
• Let I1 = $108,000 and I2 = $0
• What is the risk premium now?
• .5 + 0 =
• .5 =

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• RP = $27,000
• Risk premium rises when variance rises, EV the same

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Lottery
• You have purchased a new car
• If no wreck, you will have $50,000 of income available for
consumption of the goods and services
• If you have a wreck and are uninsured, you would expect to pay
$10,000 for repairs

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• This would leave just $40,000 available for consumption of other
goods and services
• Assume the probability of a wreck is 0.05
• EV = .95($50000)+.05($40000) = $49,500
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The Demand for Insurance
• Insurance:
– Coverage = $10,000
– Price = $500
– $49,500 sure thing.
• Why?

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– In a good state, receive $50,000 - $500 = $49,500
– In a bad state, receive $40,000 + $10,000 - $500 = $49,500

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The Demand for Insurance Continued
• If you are risk averse, you prefer to insure this way over
no insurance
• Why?
• Full coverage = no risk so prefer all else equal
• A fairly priced insurance policy is one in which the

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insurance premium (price) equals the expected value of
the promised payout
– $500 = .05($10,000) + .95($0)
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The Supply of Insurance
• Insurance company expects to break even and assumes
all risk
– Why would an insurance company ever offer this policy?
• Asymmetric information is a situation in which one party
knows more about its own actions or characteristics than

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another party
• This is why car insurance has a deductable

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Adverse Selection and Moral Hazard
• Adverse selection is opportunism characterized by an
informed person's benefiting from trading or otherwise
contracting with a less informed person who does not
know about an unobserved characteristic of the informed
person

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• Moral hazard is opportunism characterized by an
informed person's taking advantage of a less informed
person through an unobserved action

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Adverse Selection and Moral Hazard Example

• Lottery:
– $50,000 if no blindness (p = .95)
– $40,000 if blindness (1-p = .05)
– EV = $49,500
• Fair insurance:

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– Coverage = $10,000
– Price = $500
– $500 = .05(10,000) + .95(0)
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Adverse Selection and Market Failure
• Suppose that each individual's • Suppose we raise the price of
probability of blindness differs  the policy to $1,000?
[0,1]
• Now, (1-p)'' = .20
• Who will buy this policy?
• EV of payout = .2(10,000)
• Now, (1-p)' = .10 so that:
+ .8(0) = $2,000
• EV of payout = .1(10,000) + .9(0)

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• So the insurance company still
= $1000 while price of policy is
only $500
does not break even and thus
the market fails
• The insurance company no
longer breaks even
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Decision Trees
• A decision tree is a diagram that describes the options available to a
decision maker, as well as the risky events that can occur at each
point in time
• Key elements:
1. Decision nodes
2. Chance nodes

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3. Probabilities
4. Payoffs
• We analyze decision problems by working backward along the
decision tree to decide what the optimal decision would be
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Decision Tree for Oil Company’s Facility Size
Decision

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Steps in Constructing and Analyzing the Tree

1. Map out the decision and event sequence

2. Identify the alternatives available for each decision
3. Identify the possible outcomes for each risky event
4. Assign probabilities to the events

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5. Identify payoffs to all the decision/event combinations
6. Find the optimal sequence of decisions

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Perfect Information
• When faced with risky decisions,
decision makers benefit from
information that helps them
reduce or even eliminate the risk
• The value of perfect information
is the increase in the decision
maker's expected payoff when
the decision maker can -- at no
cost -- obtain information that
reveals the outcome of the risky
event
• Expected payoff to conducting test:
$35M
• Expected payoff to not conducting
test: $30M
• The value of information: $5M
• The value of information reflects the
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value of being able to tailor your
decisions to the conditions that will
actually prevail in the future
• It should represent the agent's
willingness to pay for a "crystal ball"
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Auction Formats
• English Auction – Participants cry out their bids
– Each participant can increase their bid until the auction ends with the highest bidder
winning the object being sold
• First-Price Sealed-Bid Auction – Each bidder submits one bid, not knowing the
other bids
– The highest bidder wins the object and pays a price equal to his or her bid

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• Second-Price Sealed-Bid Auction – Each bidder submits one bid, not knowing
the other bids
– The highest bidder wins the object but pays a price equal to the second-highest bid
• Dutch Descending Auction – The seller of the object announces a price which
is then lowered until a buyer announces a desire to buy the item at that price
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Private Values versus Common Values
• Private Values – A situation in which each bidder in an auction has his or
her own personalized valuation of the object
• Revenue Equivalence Theorem – When participants in an auction have
private values, any auction format will, on average, generate the same
revenue for the seller
• Common Values – A situation in which an item being sold in an auction

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has the same intrinsic value to all buyers, but no buyer knows exactly
what that value is
• Winner’s Curse – A phenomenon whereby the winning bidder in a
common-values auction might bid an amount that exceeds the item’s
intrinsic value
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First-Price Sealed-Bid Auction
• Suppose you and other bidders are competing to
purchase an antique dining room.
• You know the table is worth $1000 to you.
• You do not know the valuations of other bidders.
• You believe that some bidders could have valuations

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above or below $1000.

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First-Price Sealed-Bid Auction
• What is your best strategy?
• Optimal strategy is to submit a bid less than your
willingness to pay.
• Why?

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 First-Price Sealed-Bid Auction

40

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First-Price Sealed-Bid Auction
• If you bid $1000, the expected value of your payment is:
A+B+C+D+E+F
• Your expected payment is A+B+C+D+E+F.
• Thus your profit is $0.

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First-Price Sealed-Bid Auction
• If you bid $900, the expected value of your payment is:
D+E+F
• Your expected payment is E+F
• Thus your profit is D.
• When you shade your bid, your expected payment goes

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down by more than your expected benefit.
• You have an expected profit equal to D.

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First-Price Sealed-Bid Auction
• If you bid $900, the expected value of your payment is:
D+E+F
• Your expected payment is E+F
• Thus your profit is D.
• When you shade your bid, your expected payment goes

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down by more than your expected benefit.
• You have an expected profit equal to D.

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First-Price Sealed-Bid Auction
• By how much should you shade your bid?
Depends on your beliefs about other bidders’ strategies,
that in turn depends on your beliefs about their valuations.

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Summary
1. We can think of risky decisions as lotteries
2. We can think of individuals maximizing expected utility when
faced with risk
3. Individuals differ in their attitudes towards risk: those who prefer
a sure thing are risk averse

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– Those who are indifferent about risk are risk neutral
– Those who prefer risk are risk loving
4. Insurance can help to avoid risk
– The optimal amount to insure depends on risk attitudes.
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Summary Continued
5. The provision of insurance by individuals does not require risk
lovers
6. Adverse selection and moral hazard can cause inefficiency in
insurance markets
7. We can calculate the value of obtaining information in order to
reduce risk by analyzing the expected payoff to eliminating risk

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from a decision tree and comparing this to the expected payoff of
maintaining risk
8. The main types of auctions are private values auctions and
common values auctions
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