Chapter 5

Uncertainty and Consumer Behavior

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Chapter 5

Topics to be Discussed
Describing Risk
Preferences Toward Risk

Reducing Risk
The Demand for Risky Assets
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Introduction
Choice with certainty is reasonably straightforward How do we make choices when certain variables such as income and prices are uncertain (making choices with risk)?

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Describing Risk
To measure risk we must know:
1. All of the possible outcomes

2. The probability or likelihood that each outcome will occur

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Describing Risk
Interpreting Probability
1. Objective Interpretation
Based on the observed frequency of past events Based on perception that an outcome will occur

2. Subjective Interpretation

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Describing Risk
With an interpretation of probability, must determine 2 measures to help describe and compare risky choices
1. Expected value 2. Variability

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Expected Value
The weighted average of the payoffs or values resulting from all possible outcomes Expected value measures the central tendency; the payoff or value expected on average

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Expected Value
In general, for n possible outcomes: Possible outcomes having payoffs X1, X2, , Xn Probabilities of each outcome is given by Pr1, Pr2, , Prn

E(X) Pr1 X 1 Pr 2 X 2 ... Pr n X n

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Variability
The extent to which possible outcomes of an uncertain event may differ How much variation exists in the possible choice

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An Example
Suppose you are choosing between two part-time sales jobs that have the same expected income ($1,500) The first job is based entirely on commission The second is a salaried position

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Outcome 1 Prob. Income 2000 1510

Outcome 2 Prob. .5 .01 Income 1000 510

Job 1: Commission
Job 2: Fixed Salary

.5 .99

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Job 1 Expected Income

E(X 1 ) .5($2000) .5($1000) $1500

Job 2 Expected Income

E(X 2 ) .99($1510) .01($510) $1500

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Variability
While the expected values are the same, the variability is not Greater variability from expected values signals greater risk Variability comes from deviations in payoffs
Difference between expected payoff and actual payoff
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Variability
We can measure variability with standard deviation
The square root of the average of the squares of the deviations of the payoffs associated with each outcome from their expected value

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Variability
Standard deviation is a measure of risk
Measures how variable your payoff will be More variability means more risk Individuals generally prefer less variability less risk
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Variability
The standard deviation is written:

Pr1X1 E ( X ) Pr2 X 2 E ( X )
2

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Standard deviations of the two jobs are:

Pr1X1 E ( X )2 Pr2 X 2 E ( X )2
1 0.5($250 ,000 ) 0.5($250 ,000 ) 1 250 ,000 500
2 0.99 ($ 100 ) 0.01($980 ,100 ) 2 9,900 99 .50
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Decision Making
Which job should be chosen if the expected values are different?
Depends on the individual Some may be willing to take risk with higher expected income Some will prefer less risk even with lower expected income

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Risk and Crime Deterrence

Attitudes toward risk affect willingness to break the law Suppose a city wants to deter people from double parking Monetary fines may be better than jail time

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Preferences Toward Risk

Can expand evaluation of risky alternative by considering utility that is obtained by risk
A consumer gets utility from income Payoff measured in terms of utility
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Example
A person is earning $15,000 and receiving 13.5 units of utility from the job She is considering a new, but risky job
0.50 chance of $30,000 0.50 chance of $10,000

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Example
Utility at $30,000 is 18 Utility at $10,000 is 10 Must compare utility from the risky job with current utility of 13.5 To evaluate the new job, we must calculate the expected utility of the risky job
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Preferences Toward Risk

The expected utility of the risky option is the sum of the utilities associated with all her possible incomes weighted by the probability that each income will occur
E(u) = (Prob. of Utility 1) *(Utility 1) + (Prob. of Utility 2)*(Utility 2)

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Example
The expected is:
E(u) = (1/2)u($10,000) + (1/2)u($30,000) = 0.5(10) + 0.5(18) = 14
E(u) of new job is 14, which is greater than the current utility of 13.5 and therefore preferred

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Preferences Toward Risk

People differ in their preference toward risk People can be risk averse, risk neutral, or risk loving

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Risk Averse
A person who prefers a certain given income to a risky income with the same expected value The person has a diminishing marginal utility of income Most common attitude towards risk
Ex: Market for insurance

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Risk Averse Example

Expected Income of Risky Job
E(I) = (0.5)($30,000) + (0.5)($10,000) E(I) = $20,000

Expected Utility of Risky Job

E(u) = (0.5)(10) + (0.5)(18) E(u) = 14

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Risk Averse Example

Expected income from both jobs is the same risk averse may choose current job Expected utility is greater for certain job
Would keep certain job

Risk averse persons losses (decreased utility) are more important than risky gains

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Risk Averse Utility Function

Utility

E
D C F
The consumer is risk averse because she would prefer a certain income of $20,000 to an uncertain expected income = $20,000

18
16 14

A 10

0
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10

16 20
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Income ($1,000)
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Risk neutral
A person is said to be risk neutral if they show no preference between a certain income, and an uncertain income with the same expected value Constant marginal utility of income

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Risk Neutral
Utility 18
E

12

The consumer is risk neutral and is indifferent between certain events and uncertain events with the same expected income.

0
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10

20
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Income ($1,000)
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Risk loving
A person is said to be risk loving if they show a preference toward an uncertain income over a certain income with the same expected value
Examples: Gambling, some criminal activities

Increasing marginal utility of income

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Risk Loving
Utility 18 E
The consumer is risk loving because she would prefer the gamble to a certain income.

10.5
8 A 3 0
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F C

10

20
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Income ($1,000)
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Risk premium
The risk premium is the maximum amount of money that a risk-averse person would pay to avoid taking a risk The risk premium depends on the risky alternatives the person faces

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Risk Premium Example

Utility Risk Premium G
20 18
14
Here, the risk premium is $4,000 because a certain income of $16,000 gives the person the same expected utility as the uncertain income with expected value of $20,000.

E
C

A
10

0
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10

16

20
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40

Income ($1,000)
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Risk Aversion and Income

Example:
A job has a .5 probability of paying $40,000 (utility of 20) and a .5 chance of paying 0 (utility of 0).

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Risk Aversion and Income

Variability in potential payoffs increases the risk premium The greater the variability, the more the person would be willing to pay to avoid the risk, and the larger the risk premium

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Risk Aversion and Indifference Curves

Expected Income

U3 U2 U1

Highly Risk Averse: An increase in standard deviation requires a large increase in income to maintain satisfaction.

Standard Deviation of Income

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Risk Aversion and Indifference Curves

Expected Income Slightly Risk Averse: A large increase in standard deviation requires only a small increase in income to maintain satisfaction.

U3
U2 U1

Standard Deviation of Income

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Reducing Risk
Consumers are generally risk averse and therefore want to reduce risk Three ways consumers attempt to reduce risk are:
1. Diversification 2. Insurance 3. Obtaining more information

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Reducing Risk
Diversification
Reducing risk by allocating resources to a variety of activities whose outcomes are not closely related

Example:
Suppose a firm has a choice of selling air conditioners, heaters, or both The probability of it being hot or cold is 0.5 How does a firm decide what to sell?
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Income from Sales of Appliances

Hot Weather Air conditioner sales Heater sales Cold Weather

$30,000

$12,000

12,000

30,000

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Diversification Example
With diversification, expected income is $21,000 with no risk Better off diversifying to minimize risk Firms can reduce risk by diversifying among a variety of activities that are not closely related

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Reducing Risk The Stock Market

If invest all money in one stock, then take on a lot of risk
If that stock loses value, you lose all your investment value

Can spread risk out by investing in many different stocks or investments

Ex: Mutual funds

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Demand for Risky Assets

Most individuals are risk averse and yet choose to invest money in assets that carry some risk
Why do they do this? How do they decide how much risk to bear?

Must examine the demand for risky assets

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Example
An investor is choosing between T-Bills and stocks:
1. T-bills riskless 2. Stocks risky

Investor can choose only T-bills, only stocks, or some combination of both

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 Rf = risk-free return on T-bill

Expected return equals actual return on a riskless asset

Rm = the expected return on stocks rm = the actual returns on stock Assume Rm > Rf or no risk averse investor would buy the stocks

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Trade-offs: Risk and Returns

How do we determine the allocation of funds between the two choices?
b = fraction of funds placed in stocks (1-b) = fraction of funds placed in T-bills

Expected return on portfolio is weighted average of expected return on the two assets

RP bRm (1 b) R f
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Trade-offs: Risk and Returns

How risky is the portfolio?
As stated before, one measure of risk is standard deviation Standard deviation of the risky asset, m Standard deviation of risky portfolio, p Can show that:

p b m
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Risk and Returns

R p bRm (1 b) R f Rp R f ( Rm R f )

Expected return on the portfolio, rp increases as the standard deviation, p of that return increases
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Risk and Returns

The slope of the line is called the price of risk
Tells how much extra risk an investor must incur to enjoy a higher expected return

Slope (Rm Rf )/ m

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Choosing Between Risk and Return

Expected Return,Rp
U2 is the optimal choice since it gives the highest return for a given risk and is still affordable

U3 U2 U1 Rm R* Rf

Budget Line

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Chapter 5

The Choices of Two Different Investors

Expected Return,Rp

UB

UA

Budget line
Given the same budget line, investor A chooses low return/low risk, while investor B chooses high return/high risk.

Rm
RB

RA R
f

A
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Standard Deviation of Return, p

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