Chapter 3: Choice under uncertainty

Chapter 3: Choice under uncertainty

Learning objectives
By the end of this chapter, and having completed the essential reading and activities, you should be able to: define risk aversion use a state-contingent diagram to analyse choice under uncertainty use expected utility theory to analyse choice under uncertainty explain why risk-averse people are willing to pay for insurance, value additional information, and hold diversified assets.

Essential reading
E, E & E, Ch. 17** E, L & D, Ch. 7** M, K & R, Ch. 6*** P & R, Ch. 5**

Introduction
The basic theory of choice provides powerful insights into many types of economic behaviour, but it is limited to situations in which the outcomes are certain. As many decisions are made without knowing for certain the consequences of those decisions, we need a model that allows us to make predictions about decision making under uncertainty. The textbooks offer two approaches the contingent-commodities (statedependent preferences) model (Morgan, Katz and Rosen, 2009) and the expected-utility model (Eaton, Eaton and Allen, 2002; Estrin, Laidler and Dietrich, 2008; and Pindyck and Rubinfeld, 2008). A good understanding of choice under uncertainty (e.g. in insurance decisions) can be obtained using either approach. However, it is recommended that both are studied. The former is particularly useful in modelling choices and market equilibria under conditions of asymmetric information (see Chapter 9) while the latter is useful in generalising decision making to more than two uncertain outcomes. Note, however, that the contingent commodities approach is more general in the sense that while the expected utility model can be re-cast in terms of the former approach, the contingent commodities approach is not dependent on the expected utility hypothesis.

Contingent commodities
M, K & R, Ch. 6 (6.1) Following Morgan, Katz and Rosen (2009), it is simplest to start with the contingent commodities approach as, with appropriate modifications, it uses the familiar tools of choice theory, namely, budget constraints and indifference curves. The fundamental modification is to introduce the concepts contingent commodity and state of the world (or state of nature). A state of the world is the outcome of an uncertain situation in a simple case there may be only two possible states, either good times or bad times. A contingent commodity is the amount of consumption
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whose level depends on which state of the world occurs. Consider a simple gambling game. (Although the most interesting economic applications are often about attempts to avoid uncertainty, textbooks usually develop the basic concepts used in the analysis of choice making under uncertainty by using gambling examples in which individuals are offered uncertainty in exchange for certainty.) Suppose that, for each dollar you bet in a coin flipping game, you win $11/2 when a head comes up and lose $1 when a tail comes up. The states of the world are: 1. head comes up 2. tail comes up. The contingent commodities are: 1. consumption if you win $11/2 2. consumption if you lose $1. The size of the bet determines the amounts of the contingent commodities. The actual outcome of the uncertain situation determines which commodity you actually receive. The budget constraint for contingent commodities shows how much of each contingent commodity you can have in each state of the world. Given your endowment point (the consumption bundle available in either state of the world when you make no trades with the market, that is, no bets) the budget constraint is a straight line through the endowment point with a slope depending on the pay-off associated with each state of the world. As usual, the slope of the budget constraint shows the opportunity cost of one (contingent) commodity in terms of the other. In our example, the cost of increasing consumption by $11/2 if a head comes up is a loss of $1 if a tail comes up. Note that, unlike a typical budget constraint, after the state of the world has been determined, you only get to consume one contingent commodity, the one on the axis associated with the state of the world that actually occurs. The next step is to introduce the concepts of probability and expected value and to derive the fair odds line. The probability of a given state of the world is a measure of the likelihood that it occurs. It is expressed as a number between 0 (will not occur with certainty) and 1 (will occur with certainty). In our example, the probability that a head (tail) comes up is 1/2. Expected value is the value that is expected to occur on average, that is, the weighted sum of the outcomes, the weights being the probability of each outcome occurring. In our example, you can expect to have net winnings of $1/4 [= 1/2($11/2) + 1/2($1)] for each dollar you bet. The fair odds line is a budget constraint reflecting the opportunities presented by an actuarially fair gamble. Along the fair odds line, the expected value of the gamble is always zero. Thus, a fair gamble would be one in which for each dollar you bet in a coin flipping game, you win $1 when a head comes up and lose $1 when a tail comes up. The absolute value of the slope of the fair odds line is equal to the ratio of the probabilities. It represents the odds of the two states of the world occurring and expresses how likely one state is in relation to another. For a fair coin toss the ratio is (1/2)/(1/2) = 1, or even odds. As well as budget constraints representing opportunities in uncertain situations we can also construct indifference maps to represent preferences for contingent commodities. In uncertain situations, not only the individuals attitudes toward the contingent commodities must be considered, but the individuals attitudes toward risk must be included as well. The curvature of the indifference curve depends on whether
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the individual is risk-averse, -neutral, or -loving. A person is said to be risk-averse (thought to be the most common case) when the person prefers a certain prospect with a particular expected value to an uncertain prospect with the same expected value. A risk-averse person rejects a fair bet because of the uncertainty it creates. Thus, it can be shown that a risk-averse persons indifference curves bow toward the origin. Moreover, the absolute value of the slope of each indifference curve as it intersects the certainty line (the locus of all possible certain consumption levels, representing consumption levels when the person refuses to gamble, and hence a 45 degree line beginning at the origin) is equal to the odds in favour of the event on the horizontal axis. Finally, as usual, the individuals choice is determined where the budget constraint is tangent to the highest indifference curve. The following intuitively reasonable result can be demonstrated. A risk-averse person will choose to risk some money if a bet is favourable as in our (first) example of a coin flipping game, but will not accept a fair bet.

Insurance
M, K & R, Ch. 6 (6.3) Once the foregoing apparatus and terminology have been mastered they can be applied to various problems involving choice under conditions of uncertainty. In particular, insurance decisions should be studied, for their own value as important applications of the theory, but also because these decisions are of special interest when problems associated with asymmetric information are examined later in the subject guide. Analysis yields the following important results. Risk-averse people purchase insurance in order to spread consumption more evenly across states of the world. When risk-averse people can purchase actuarially fair insurance that is, where the premium paid to obtain the insurance equals the expected payout of the insurance they will choose to insure themselves fully, in the sense that their consumption is the same in every state of the world. More realistically, people pay actuarially unfair insurance because premiums need to cover operating expenses. When the premium is more than the expected payout a risk-averse person purchases less than full insurance. Assuming the premium remains unchanged, an individual perceiving a higher probability of loss will buy more insurance.

Expected utility
E, E & A, Ch. 17 (17.1) E, L & D, Ch. 7 (pp.11721) M, K & R, Ch. 6 (6.4) P & R, Ch. 5 (5.1 and 5.2) The budget constraint-indifference curve analysis works well when analysing choice between two contingent commodities. However, when analysing choices between more than two contingent commodities it is necessary to specify a utility function whose value depends on the quantities of each of the contingent commodities and their associated probabilities. In principle, the probabilities of the various states of the world can enter into the utility function in quite complex ways, but a relatively simple one of great empirical relevance is the von NeumannMorgenstern (vN-M) utility function.
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With a vN-M utility function, the utility associated with some uncertain event is the expected value of the utilities of each of the possible outcomes. You should understand that with a vN-M utility function, rational behaviour calls for maximising the expected value of utility, not expected monetary value and not the utility of the expected monetary value. The expected-utility hypothesis depends on a specific set of assumptions but you are not required to know about these in detail or the controversy surrounding them. You are expected to know how attitudes to risk are related to the slope of the utility of wealth (or income) schedule; in particular, a risk-averse person is said to have a diminishing marginal utility of wealth (or income) as the utility of wealth (income) schedule of such a person is concave from below. The expected-utility approach can be used to analyse insurance decisions (Eaton, Eaton and Allen, 2002, pp.56064, Estrin, Laidler and Dietrich, 2008, pp.12226, and Pindyck and Rubinfeld, 2008, pp.17273). But, assuming that you use the contingent commodities approach to do this analysis, you should concentrate on the application of the expected-utility hypothesis to the analysis of other ways of reducing risk. In particular, an individual can reduce risk by obtaining additional information and by diversification. The decision an individual makes when outcomes are uncertain is based on limited information. You should understand how the acquisition of information can reduce uncertainty and improve decisions. Information is valuable and it is worth incurring some costs to acquire it. It can raise expected values (Pindyck and Rubinfeld, 2008, pp.17476) and expected utility (Morgan, Katz and Rosen, 2009, pp.207 09). You should also understand why theory predicts that risk-averse individuals will diversify. By holding a variety of assets (Morgan, Katz and Rosen, 2009, pp.19192) or by working in a variety of activities (Pindyck and Rubinfeld, 2008, pp.17071) that is, by diversification a riskaverse individual can reduce risk without necessarily reducing expected value and thereby maximise expected utility.

A reminder of your learning outcomes

Having completed this chapter, and the essential reading and activities, you should be able to: define risk aversion use a state-contingent diagram to analyse choice under uncertainty use expected utility theory to analyse choice under uncertainty explain why risk-averse people are willing to pay for insurance, value additional information, and hold diversified assets.

Sample examination questions

1. Rebecca has an income of $100. She is offered the following bet: A die is thrown. If a one comes up, Rebecca loses $1. If a two, three, four, five or six comes up, she wins $2. Rebecca can take either side of the bet, and she is risk averse. i. What are the contingent commodities in this problem? ii. Sketch the budget constraint and indifference curves. iii. Show on the diagram the amount that Rebecca bets. iv. Sketch the fair odds line associated with this bet. How much does she bet if the odds are fair?
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2. When an insurance policy is actuarially fair, a risk-averse person will purchase less than full insurance. True, false, or uncertain? Explain your answer. 3. What does it mean for consumers to be expected utility maximisers? Suppose that Peters utility function is given by U(Y) = Y, where Y represents annual income in thousands of dollars. Is Peter risk-loving, risk-neutral, or risk-averse? Section B 1. Explain how, with appropriate modifications, the standard tools of choice theory (i.e. budget constraints and indifference curves) can be used to analyse a gambling decision by a risk-averse person. 2. With reference to EITHER the contingent commodities approach OR the expected utility approach to the analysis of choice under uncertainty, examine how insurance can help risk-averse individuals deal with risk. 3. Explain how risk can be reduced by: i. purchasing insurance ii. obtaining additional information iii. diversification.

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