CH 18

Chapter 18
UNCERTAINTY AND
RISK AVERSION
Copyright ©2005 by South-Western, a division of Thomson Learning. All rights reserved. c

0robability
G The probability of a repetitive event
happening is the relative frequency with
which it will occur
± probability of obtaining a head on the fair-flip
of a coin is 0.5
G If a lottery offers a distinct prizes and the
probabilities of winning the prizes are gd
ri=1,a) then
a
· c
c
©
9 pected Value
G or a lottery rë) with prizes 1, 2,«, a
and the probabilities of winning
g1,g2,«ga, the expected value of the
lottery
is( ) g g ... g
1 1 2 2 a a
a
·
c
G The expected value is a weighted sum of

the outcomes
± the weights are the respective probabilities ]
9 pected Value
G Suppose that Smith and Jones decide to
flip a coin
± heads r 1) Jones will pay Smith $1
± tails r 2) Smith will pay Jones $1
G rom Smith¶s point of view,
( g1m1 g m
ë Î ÎÀ

9 pected Value
G ames which have an expected value of
zero ror cost their expected values) are
called actuarially fair games
± a common observation is that people often
refuse to participate in actuarially fair games
×
6air Games
G eople are generally unwilling to play
fair games
G There may be a few exceptions
± when very small amounts of money are at
stake
± when there is utility derived from the actual
play of the game
G we will assume that this is not the case
ü
Út. 0etersburg 0arado
G A coin is flipped until a head appears
G If a head appears on the ath flip, the
player is paid $2a
1 = $2, 2 = $4, 3 = $8,«, = $2a
a
G The probability of getting of getting a

head on the dth trial is r)d
g1=, g2= ¼,«, ga= 1/2a
*
Út. 0etersburg 0arado
G The expected value of the St. etersburg
paradox game is infinite
d
c
· d d · d

d c d c
( ë ) c c c ... c
G ecause no player would pay a lot to
play this game, it is not worth its infinite
expected value
m
9 pected Utility
G Individuals do not care directly about the
dollar values of the prizes
± they care about the utility that the dollars
provide
G If we assume diminishing marginal utility of
wealth, the St. etersburg game may
converge to a finite expected utility value
± this would measure how much the game is
worth to the individual

9 pected Utility
G Expected utility can be calculated in the
same manner as expected value
a
·
G ecause utility may rise less rapidly than

the dollar value of the prizes, it is
possible that expected utility will be less
than the monetary expected value
c
ghe von Neumann-
Morgenstern gheorem
G Suppose that there are a possible
prizes that an individual might win
r 1,« a) arranged in ascending order of
desirability
± 1 = least preferred prize Ur 1) = 0
± a = most preferred prize Ur a) = 1
cc
ghe von Neumann-
Morgenstern gheorem
G The point of the von Neumann-
Morgenstern theorem is to show that
there is a reasonable way to assign
specific utility numbers to the other prizes
available
c©
ghe von Neumann-
Morgenstern gheorem
G The von Neumann-Morgenstern method
is to define the utility of d as the
expected utility of the gamble that the
individual considers equally desirable to
d
Ur d) = gd> Ur a) + r1 - gd) > Ur 1)
c]
ghe von Neumann-
Morgenstern gheorem
G Since Ur a) = 1 and Ur 1) = 0
Ur d) = gd> 1 + r1 - gd) > 0 = gd
G The utility number attached to any other
prize is simply the probability of winning it
G Note that this choice of utility numbers is
arbitrary
c
9 pected Utility Ma imization
G A rational individual will choose among
gambles based on their expected
utilities rthe expected values of the von
Neumann-Morgenstern utility index)
c×
G Consider two gambles:
± first gamble offers 2 with probability and
3 with probability r1-)
expected utility r1) = > Ur 2) + r1-) > Ur 3)

± second gamble offers 5 with probability
and 6 with probability r1-)
expected utility r2) = > Ur 5) + r1-) > Ur 6)
cü
G Substituting the utility index numbers
gives
expected utility r1) = > g2 + r1-) > g3
expected utility r2) = > g5 + r1-) > g6
G The individual will prefer gamble 1 to
gamble 2 if and only if
> g2 + r1-) > g3 > > g5 + r1-) > g6
c*
G If individuals obey the von Neumann-
Morgenstern axioms of behavior in
uncertain situations, they will act as if
they choose the option that maximizes
the expected value of their von
Neumann-Morgenstern utility index
cm
Pisk Aversion
G Two lotteries may have the same
expected value but differ in their riskiness
± flip a coin for $1 versus $1,000
G Risk refers to the variability of the
outcomes of some uncertain activity
G When faced with two gambles with the
same expected value, individuals will
usually choose the one with lower risk
c
Pisk Aversion
G In general, we assume that the marginal
utility of wealth falls as wealth gets larger
± a flip of a coin for $1,000 promises a small
gain in utility if you win, but a large loss in
utility if you lose
± a flip of a coin for $1 is inconsequential as
the gain in utility from a win is not much
different as the drop in utility from a loss
©
Pisk Aversion
UrW) is a von Neumann-Morgenstern
Utility rU) utility index that reflects how the individual
feels about each value of wealth
UrW)
The curve is concave to reflect the

assumption that marginal utility
diminishes as wealth increases
Wealth rW)
©c
Pisk Aversion
Suppose that W* is the individual¶s current
Utility rU)
level of income
UrW)
U(W
UrW*) is the individual¶s

current level of utility
3 Wealth rW)
©©
Pisk Aversion
G Suppose that the person is offered two
fair gambles:
± a 50-50 chance of winning or losing $Ê
UÊrW*) = UrW* + Ê) + UrW* - Ê)
± a 50-50 chance of winning or losing $2Ê
U2ÊrW*) = UrW* + 2Ê) + UrW* - 2Ê)
©]
Pisk Aversion
The expected value of gamble 1 is UÊrW*)
Utility rU)
UrW)
(W
(W
3 - 3 3 + Wealth rW)
©
Pisk Aversion
The expected value of gamble 2 is U2ÊrW*)
Utility rU)
UrW)
(W
2(W
Wealth rW)
3 - 2 3 3 + 2
©×
Pisk Aversion
Utility rU)
UrW*) > UÊrW*) > U2ÊrW*)
UrW)
(W
(W
2(W
Wealth rW)
3 - 2 3 - 3 3 + 3 + 2
©ü
Pisk Aversion
G The person will prefer current wealth to
that wealth combined with a fair gamble
G The person will also prefer a small
gamble over a large one
©*
Pisk Aversion and Insurance
G The person might be willing to pay
some amount to avoid participating in a
gamble
G This helps to explain why some
individuals purchase insurance
©m
Pisk Aversion and insurance
W´ provides the same utility as
Utility rU) participating in gamble 1
UrW)
(W
(W
The individual will be
willing to pay up to
W* - W´ to avoid
participating in the
gamble
Wealth rW)
3 - 3È 3 3 +
©
Pisk Aversion and Insurance
G An individual who always refuses fair
bets is said to be risk averse
± will exhibit diminishing marginal utility of
income
± will be willing to pay to avoid taking fair
bets
]
Willingness to 0ay for
Insurance
G Consider a person with a current wealth
of $100,000 who faces a 25% chance of
losing his automobile worth $20,000
G Suppose also that the person¶s von
Neumann-Morgenstern utility index is
UrW) = la rW)
]c
Insurance
G The person¶s expected utility will be
9rU) = 0.75Ur100,000) + 0.25Ur80,000)
9rU) = 0.75 lar100,000) + 0.25 lar80,000)
9rU) = 11.45714
G In this situation, a fair insurance premium

would be $5,000 r25% of $20,000)
]©
Insurance
G The individual will likely be willing to pay
more than $5,000 to avoid the gamble. How
much will he pay?
9rU) = Ur100,000 - ) = lar100,000 - ) = 11.45714
100,000 - = 11.45714
= 5,426
G The maximum premium is $5,426
]]
Measuring Pisk Aversion
G The most commonly used risk aversion
measure was developed by ratt
"3
3 [
'3
G or risk averse individuals, U´rW) < 0
± rrW) will be positive for risk averse
individuals
± rrW) is not affected by which von
Neumann-Morganstern ordering is used ]
G The ratt measure of risk aversion is
proportional to the amount an individual
will pay to avoid a fair gamble
]×
G Let Ê be the winnings from a fair bet
9rÊ) = 0
G Let be the size of the insurance
premium that would make the individual
exactly indifferent between taking the
fair bet Ê and paying with certainty to
avoid the gamble
9[UrW + Ê)] = UrW - )
]ü
G We now need to expand both sides of
the equation using Taylor¶s series
G ecause is a fixed amount, we can
use a simple linear approximation to the
right-hand side
UrW - ) = UrW) - U¶rW) + higher order terms
]*
G or the left-hand side, we need to use a
quadratic approximation to allow for the
variability of the gamble rÊ)
9[UrW + Ê)] = 9[UrW) - ÊU¶rW) + Ê2/2 U´rW)

+ higher order terms
9[UrW + Ê)] = UrW) - 9rÊ)U¶rW) + 9rÊ2)/2 U´rW)
+ higher order terms
]m
G Remembering that 9rÊ)=0, dropping the
higher order terms, and substituting
for 9rÊ2)/2, we get
(3 ) ' (3 ) (3 ) Õ " (3 )
3
Î 3
' 3
]
Pisk Aversion and Wealth
G It is not necessarily true that risk aversion
declines as wealth increases
± diminishing marginal utility would make
potential losses less serious for high-wealth
individuals
± however, diminishing marginal utility also
makes the gains from winning gambles less
attractive
G the net result depends on the shape of the utility
function

G If utility is quadratic in wealth
UrW) = a + bW + cW 2
where b > 0 and c < 0
G ratt¶s risk aversion measure is
U W ©c
W
U W b Õ ©cW
G Riskaversionincreasesaswealth
increases c
G If utility is logarithmic in wealth
UrW) = la rW )
where W > 0
U W c
W Î Î
U W W
G Riskaversiondecreasesaswealth
increases ©
G If utility is exponential
UrW) = --W = - r-W)
where is a positive constant
U W © W
W
U W W
G Riskaversionisconstantaswealth
increases ]
Pelative Pisk Aversion
G It seems unlikely that the willingness to
pay to avoid a gamble is independent of
wealth
G A more appealing assumption may be
that the willingness to pay is inversely
proportional to wealth

G This relative risk aversion formula is
3
3 3 3 3
3
×
G The power utility function
UrW) = WR/R for R < 1, 0
exhibits diminishing absolute relative
risk aversion
[
3 [ 3 [
3 [ [ [
3 3 [ 3
but constant relative risk aversion

[P [ c c[ P
ü
ghe Útate-0reference
Approach
G The approach taken in this chapter up
to this point is different from the
approach taken in other chapters
± has not used the basic model of utility-
maximization subject to a budget constraint
G There is a need to develop new
techniques to incorporate the standard
choice-theoretic framework
*
Útates of the World
G Outcomes of any random event can be
categorized into a number of states of
the world
± ³good times´ or ³bad times´
G Contingent commodities are goods
delivered only if a particular state of the
world occurs
± ³$1 in good times´ or ³$1 in bad times´
m
Útates of the World
G It is conceivable that an individual could
purchase a contingent commodity
± buy a promise that someone will pay you
$1 if tomorrow turns out to be good times
± this good will probably cost less than $1

Utility Analysis
G Assume that there are two contingent
goods
± wealth in good times rWg) and wealth in bad
times rWb)
± individual believes the probability that good
times will occur is g
×
Utility Analysis
G The expected utility associated with these
two contingent goods is
rWg,Wb)gUrWg) + r1 - g)UrWb)
G This is the value that the individual wants
to maximize given his initial wealth rW)
×c
0rices of Contingent
Commodities
G Assume that the person can buy $1 of
wealth in good times for g and $1 of
wealth in bad times for b
G His budget constraint is
W = gWg + bWb
G The price ratio g /b shows how this
person can trade dollars of wealth in good
times for dollars in bad times ×©
6air Markets for Contingent
Goods
G If markets for contingent wealth claims are
well-developed and there is general
agreement about g, prices for these goods
will be actuarially fair
g = g and b = r1- g)
G The price ratio will reflect the odds in favor
of good times
g
î g ×]
Pisk Aversion
G If contingent claims markets are fair, a
utility-maximizing individual will opt for a
situation in which Wg = Wb
± he will arrange matters so that the wealth
obtained is the same no matter what state
occurs
×
Pisk Aversion
G Maximization of utility subject to a budget
constraint requires that

î î î
G If markets for contingent claims are fair

c
î
î ××
Pisk Aversion
The individual maximizes utility on the
Wb
certainty line where Wg = Wb
certainty line
Since the market for contingent

claims is actuarially fair, the
3 slope of the budget constraint = -1
U1
Wg
3
×ü
Pisk Aversion
In this case, utility maximization may not
Wb occur on the certainty line
certainty line
If the market for contingent

claims is not fair, the slope of
U1 the budget line c
Wg
×*
Insurance in the Útate-
0reference Model
G Again, consider a person with wealth of
$100,000 who faces a 25% chance of
losing his automobile worth $20,000
± wealth with no theft rWg) = $100,000 and
probability of no theft = 0.75
± wealth with a theft rWb) = $80,000 and
probability of a theft = 0.25
×m
0reference Model
G If we assume logarithmic utility, then
9rU) = 0.75UrWg) + 0.25UrWb)
9rU) = 0.75 laWg + 0.25 laWb
9rU) = 0.75 la r100,000) + 0.25 la r80,000)
9rU) = 11.45714
×
0reference Model
G The budget constraint is written in terms of
the prices of the contingent commodities
gWg* + bWb* = gWg + bWb
G Assuming that these prices equal the
probabilities of these two states
0.75r100,000) + 0.25r80,000) = 95,000
G The expected value of wealth = $95,000
ü
0reference Model
G The individual will move to the certainty line
and receive an expected utility of
9rU) = la 95,000 = 11.46163
± to be able to do so, the individual must be able
to transfer $5,000 in extra wealth in good times
into $15,000 of extra wealth in bad times
G a fair insurance contract will allow this
G the wealth changes promised by insurance
rWb/Wg) = 15,000/-5,000 = -3
üc
A 0olicy with a Deductible
G Suppose that the insurance policy costs
$4,900, but requires the person to incur
the first $1,000 of the loss
Wg = 100,000 - 4,900 = 95,100
Wb = 80,000 - 4,900 + 19,000 = 94,100
9rU) = 0.75 la 95,100 + 0.25 la 94,100
9rU) = 11.46004
G The policy still provides higher utility than
doing nothing
ü©
Pisk Aversion and Pisk
0remiums
G Consider two people, each of whom
starts with an initial wealth of W*
G Each seeks to maximize an expected
utility function of the form
W W
V W ,W g Õ c g
G This utility function exhibits constant

relative risk aversion ü]
0remiums
P P
î
î g c g
P P
G The parameter R determines both the

degree of risk aversion and the degree of
curvature of indifference curves implied by
the function
± a very risk averse individual will have a large
negative value for R
ü
0remiums
Wb A very risk averse person will have sharply curved
indifference curves such as U1
certainty line
A person with more tolerance

for risk will have flatter
indifference curves such as U2
3
U1
U2
Wg
3
ü×
0remiums
Wb Suppose that individuals are faced with losing Ê
dollars in bad times
certainty line
The difference between W1
and W2 shows the effect of
risk aversion on the
3 willingness to accept risk
3 - h U1
U2
Wg
3 32 31
üü
Important 0oints to Note:
G In uncertain situations, individuals are
concerned with the expected utility
associated with various outcomes
± if they obey the von Neumann-
Morgenstern axioms, they will make
choices in a way that maximizes expected
utility
ü*
G If we assume that individuals exhibit a
diminishing marginal utility of wealth,
they will also be risk averse
± they will refuse to take bets that are
actuarially fair
üm
G Risk averse individuals will wish to
insure themselves completely against
uncertain events if insurance
premiums are actuarially fair
± they may be willing to pay actuarially
unfair premiums to avoid taking risks
ü
G Decisions under uncertainty can be
analyzed in a choice-theoretic framework
by using the state-preference approach
among contingent commodities
± if preferences are state independent and
prices are actuarially fair, individuals will
prefer allocations along the ³certainty line´
G will receive the same level of wealth regardless
of which state occurs
*

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Chapter 18

Copyright ©2005 by South-Western, a division of Thomson Learning. All rights reserved. c

G The expected value is a weighted sum of

G The probability of getting of getting a

G ecause utility may rise less rapidly than

expected utility r1) = > Ur 2) + r1-) > Ur 3)

The curve is concave to reflect the

UrW*) is the individual¶s

G In this situation, a fair insurance premium

UrW - ) = UrW) - U¶rW) + higher order terms

9[UrW + Ê)] = 9[UrW) - ÊU¶rW) + Ê2/2 U´rW)

G This relative risk aversion formula is

but constant relative risk aversion

Since the market for contingent

If the market for contingent

G This utility function exhibits constant

G The parameter R determines both the

A person with more tolerance

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