Chapter 5

Uncertainty and Consumer Behaviour

Microeconomics, 9th Edition

Copyright © 2018 Pearson Education Ltd. All Rights Reserved.

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 Chapter Outline
So far, we assumed that prices, incomes and other variables are known with
certainty.
In this chapter, we examine the ways that people can compare and choose
among risky alternatives in four steps:
Measures of risk
People’s preferences toward risk
Ways of reducing risk
Trade-offs in the amount of risk that people wish to bear.

5.1 Describing Risk

5.2 Preferences Toward Risk
5.3 Reducing Risk
5.4 The Demand for Risky Assets

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 5.1 Describing Risk
Probability: Likelihood that a given outcome will occur.
One objective interpretation of probability relies on the frequency with which certain
events tend to occur.
Subjective probability is the perception that an outcome will occur.
Two important measures that help us describe and compare risky choices are expected
value and variability of the possible outcomes.

Expected Value: Probability-weighted average of the payoffs associated with all

possible outcomes.
Payoff: Value associated with a possible outcome.

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 5.1 Describing Risk
The expected value measures the central tendency—the payoff or value that we would
expect on average.
Expected value = Pr(success)($40/share) + Pr(failure)($20/share)
= (1/4)($40/share) + (3/4)($20/share) = $25/share
More generally, if there are two possible outcomes, the expected value is

E(X) = Pr1 X 1 + Pr2 X 2

When there are n possible outcomes, the expected value becomes

E(X) = Pr1 X 1 + Pr2 X 2 + . . . + PrnXn

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 5.1 Describing Risk
Variability: Extent to which possible outcomes of an uncertain event differ.
Income From Sales Jobs

Outcome 1 Outcome 1 Outcome 2 Outcome 2 Blank Cell

EXPECTED
PROBABILITY INCOME ($) PROBABILITY INCOME ($)
INCOME ($)
Job 1: Commission .5 2000 .5 1000 1500
Job 2: Fixed Salary .99 1510 .01 510 1500

Deviation Extent to which possible outcomes of an uncertain event differ.

Deviations From Expected Income ($)

OUTCOME 1 DEVIATION OUTCOME 2 DEVIATION

Job 1 2000 500 1000 −500
Job 2 1510 10 510 −990

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 5.1 Describing Risk
Standard Deviation: Square root of the weighted average of the squares of the
deviations of the payoffs associated with each outcome from their expected values
Calculating Variance ($)
WIGHTED
AVERAGE
DEVIATION DEVIATION DEVIAITION STANDARD
OUTCOME 1 SQUARED OUTCOME 2 SQUARED SQUARED DEVIATION
Job 1 2000 250,000 1000 250,000 250,000 500
Job 2 1510 100 510 980,100 9900 99.50

The average of the squared deviations under Job 1 is given by

.5($250,000) + .5($250,000) = $250,000
The probability-weighted average of the squared deviations under Job 2 is
.99($100) + .01($980,100) = $9900
The standard deviations of job 1 and job 2 are $500 and $99.50, respectively. Thus the
second job is much less risky than the first; the standard deviation of the incomes is
much lower.

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 5.1 Describing Risk
Outcome Probabilities For Two Jobs Job 1 : 1000-2000: 100 increase
Job 2 : 1300-1700: 100 increase
The distribution of payoffs associated with
Job 1 has a greater spread and a greater
standard deviation than the distribution of
payoffs associated with Job 2.
Both distributions are flat because all
outcomes are equally likely.
Unequal Probability Outcomes
The distribution of payoffs associated with
Job 1 has a greater spread and a greater
standard deviation than the distribution of
payoffs associated with Job 2.
Both distributions are peaked because the
extreme payoffs are less likely than those
near the middle of the distribution.

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 5.1 Describing Risk
Decision Making
Suppose we add $100 to each of the payoffs in the first job, so that the expected payoff
increases from $1500 to $1600.
Incomes From Sales Jobs—modified ($)
Blank DEVIATION DEVIATION EXPECTED STANDARD
Cell OUTCOME 1 SQUARED OUTCOME 2 SQUARED INCOME DEVIATION

Job 1 2100 250,000 1100 250,000 1600 500

Job 2 1510 100 510 980,100 1500 99.50

The two jobs can now be described as follows:

Job 1: Expected Income = $1600 Standard Deviation = $500
Job 2: Expected Income = $1500 Standard Deviation = $99.50
Job 1 offers a higher expected income but is much riskier than Job 2.
An aggressive entrepreneur who doesn’t mind taking risks might choose Job 1, with the
higher expected income and higher standard deviation, while a more conservative person
might choose the second job.
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 5.2 Preferences Toward Risk
In this section, we concentrate on the utility that consumers obtain from choosing among
risky alternatives, in particular, the utility that a consumer gets from his or her income, or
the market basket that the consumer’s income can buy. We measure payoffs in terms of
utility rather than dollars.
Expected Utility: Sum of the utilities associated with all possible outcomes, weighted by
the probability that each outcome will occur.
In our example, a consumer has an income of $15,000 and is considering a new but risky
sales job that will either double her income to $30,000 or cause it to fall to $10,000.
Level of utility for 10,000, 20,000 and 30,000 is 10, 16 and 18. Marginal utility is
decreasing.
Each possibility has a probability of .5. The expected utility E(u) that she can obtain is

E(u ) = (1/2)u($10,000) + (1/2)u($30,000) = 0.5(10) + 0.5(18) = 14

The risky new job is preferred to the current job because the expected utility of 14 is
greater than the assumed utility of the current job, which is 13.5.

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 5.2 Preferences Toward Risk
Risk Averse: Condition of preferring a certain
income to a risky income with the same
expected value.
Risk Averse, Risk Loving, And Risk Neutral
People differ in their preferences toward risk.
In (a), a consumer’s marginal utility diminishes
as income increases.
The consumer is risk averse because she would
prefer a certain income of $20,000 (with a
utility of 16) to a gamble with a .5 probability
of $10,000 and a .5 probability of $30,000 (and
expected utility of 14).The expected utility of
the uncertain income is 14—an average of the
utility at point A (10) and the utility at E (18)—
and is shown by F.

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 5.2 Preferences Toward Risk
Risk Loving: Condition of preferring a risky
income to a certain income with the same
expected value.
Risk Averse, Risk Loving, And Risk Neutral
In (b), the consumer is risk loving: She would
prefer the same gamble (with expected utility
of 10.5) to the certain income (with a utility of
8).

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 5.2 Preferences Toward Risk
Risk Neutral: Condition of being indifferent
between a certain income and an uncertain
income with the same expected value.
Risk Averse, Risk Loving, And Risk Neutral
In (c) is risk neutral and indifferent between
certain and uncertain events with the same
expected income.

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 5.2 Preferences Toward Risk
Risk Premium: Maximum amount
of money that a risk-averse person
will pay to avoid taking a risk.
Risk Premium
The risk premium, CF, measures
the amount of income that an
individual would give up to leave
her indifferent between a risky
choice and a certain one.
Here, the risk premium is $4000
because a certain income of
$16,000 (at point C) gives her the
same expected utility (14) as the
uncertain income (a .5 probability
of being at point A and a .5
probability of being at point E) that
has an expected value of $20,000.

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 5.2 Preferences Toward Risk
Risk Aversion And Income
The extent of an individual’s risk aversion depends on the nature of the risk and on the
person’s income. Other things being equal, risk-averse people prefer a smaller variability
of outcomes.
We saw that when there are two outcomes—an income of $10,000 and an income of
$30,000—the risk premium is $4000. Now consider a second risky job, also illustrated in
Figure 5.4.
With this job, there is a .5 probability of receiving an income of $40,000, with a utility
level of 20, and a .5 probability of getting an income of $0, with a utility level of 0.
The expected income is again $20,000, but the expected utility is only 10:

Expected utility = .5u($0) + .5u($40,000) = 0 + .5(20) = 10

Risk premium in this case is 10,000.

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 5.2 Preferences Toward Risk
Risk Aversion And Indifference Curves
Part (a) applies to a person who is highly
risk averse:
An increase in this individual’s standard
deviation of income requires a large
increase in expected income if he or she
is to remain equally well off.
Part (b) applies to a person who is only
slightly risk averse:
An increase in the standard deviation of
income requires only a small increase in
expected income if he or she is to remain
equally well off.

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 5.3 Reducing Risk
Diversification: Practice of reducing risk by allocating resources to a variety of
activities whose outcomes are not closely related.
Incomes From Sales Of Appliances ($)

HOT WEATHER COLD WEATHER

Air Conditioner sales 30,000 12,000
Heater sales 12,000 30,000

If you sell only air conditioners or only heaters, your actual income will be either
$12,000 or $30,000, but your expected income will be
$21,000 (.5[$30,000] + .5[$12,000]).
If you diversify by dividing your time evenly between the two products, your income
will be $21,000, regardless of the weather. In this instance, diversification eliminates all
risk.
Negatively Correlated Variables: Variables having a tendency to move in opposite
directions.

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 5.3 Reducing Risk
The Stock Market
Mutual Fund: Organization that pools funds of individual investors to buy a large
number of different stocks or other financial assets.
Positively Correlated Variables: Variables having a tendency to move in the same
direction.
Insurance
The Decision To Insure ($) – will lose 10,000 in burglary

BURGLARY NO BURGLARY EXPECTED STANDARD

INSURANCE (PR = .1) (PR = .9) WEALTH DEVIATION
No 40,000 50,000 49,000 3000
Yes 49,000 49,000 49,000 0

For a risk-averse individual, losses count more (in terms of changes in utility) than gains.
A risk-averse homeowner, therefore, will enjoy higher utility by purchasing insurance.

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 5.3 Reducing Risk
The Law Of Large Numbers
Insurance companies are firms that offer insurance because they know that when they
sell a large number of policies, they face relatively little risk. The ability to avoid risk by
operating on a large scale is based on the law of large numbers, which tells us that
although single events may be random and largely unpredictable, the average outcome of
many similar events can be predicted.
Actuarial Fairness
When the insurance premium is equal to the expected pay-out, as in the example above,
we say that the insurance is actuarially fair.
Actuarially Fair: Characterizing a situation in which an insurance premium is equal to
the expected pay-out.

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 5.3 Reducing Risk
The Value of Information: Difference between the expected value of a choice when there is
complete information and the expected value when information is incomplete.
Profits From Sales Of Suits ($) - each option is equal likely: 0.5
cost for 100: 180 per suit / cost for 50: 200 per suit / price: 300 / return price is half of cost

SALES OF 50 SALES OF 100 EXPECTED PROFIT

Buy 50 units 5000 5000 5000
Buy 100 units 1500 12,000 6750

With complete information, you can place the correct order regardless of future sales. If sales were
going to be 50 and you ordered 50 suits, your profits would be $5000. If, on the other hand, sales
were going to be 100 and you ordered 100 suits, your profits would be $12,000. Because both
outcomes are equally likely, your expected profit with complete information would be $8500.
The value of information is computed as
Expected value with complete information: $8500
Less: Expected value with uncertainty (buy 100 suits): –6750
Equals: Value of complete information $1750

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