Uncertainty

Lecture 1 Tom Holden Intermediate Microeconomics Semester 2

http://micro2.tholden.org/

ECO2051 Intermediate Microeconomics

Introduction to Semester 2
In the second half of the module we relax some of the assumptions of the perfectly competitive model. This leads us to consider the role of government intervention. And consider some interesting ways that individuals and firms respond to uncertainty and imperfect information. As last semester, you will need to be able to solve problems but I also expect you to be able to discuss the implications of the theory for real life behaviour and policy.

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Key info (1/4): Contact details

Course website: http://micro2.tholden.org/ Email
Me: t.holden@surrey.ac.uk Your class tutor, Tina Tse: t.tse@surrey.ac.uk

Office hours:
Thursday, 2 4.
E-mailing in advance is always helpful.

Other times may be possible by (e-mail) arrangement.

Classes:
Thursdays (10-11 and 11-12)

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Key info (2/4): Readings

Main text:
V = Varian, H. (2006) Intermediate Microeconomics: A Modern Approach, Seventh edition, Norton. Other editions fine, just use the contents to find the right chapter.

Alternative:
MKR = Morgan, Katz and Rosen Microeconomics (2nd European edition) McGraw-Hill, 2009.

Additional exercises:
Bergstrom and Varian, Workouts in Intermediate Economics

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Key info (3/4): Draft timetable

Week 1 2 3 4 5 6 7 8 9 10 11 Date w/c 4/2 11/2 18/2 25/2 4/3 11/3 18/3 22/4 29/4 6/5 13/5 Topic Uncertainty 1 Uncertainty 2 + Welfare 1 Welfare 2 Externalities Public goods Inter-temporal choice Multiple Choice Test (10%) Asymmetric Information Asymmetric Information 2 Auctions Short answer test (20%) Revision and feedback on test Basic Readings V 12, MKR 6 V 33 MKR 12 (esp. p.446 onwards) V 34, MKR 18 V 36 MKR 18 V 10, MKR 5 (from p.154) V 37 MKR 17 Problem set

1. Uncertainty

2. Welfare and externalities

3. Public goods and inter-temporal choice

V 17 MKR 17

4. Asymmetric information 5. Auctions and Revision

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Key info (4/4): Draft assessment plan

Test 1:
20 question multiple choice. 60 minutes. Worth 10%. On material from weeks 1-6. Sample test given in week 6. Actual test in week 7.

Test 2:
Answer 3 short-answer questions from 6. Up to 2 hours. (Should only take around 1.) Worth 20%. On material from all weeks, but with a focus on the second half of the course. Sample test given in week 9. Actual test in week 10. 3 sections, equal weights. Section A is multiple choice. (Similar style questions to test 1.) Section B is compulsory short answer questions. (Similar style questions to test 2.) Section C asks you to answer 1 longer question from 3. 2 hours. Worth 70%. On material from all weeks. Mock exam given out in week 11.

Exam:

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Expectations
As well as mastering the concepts discussed in the lectures, you need to practice the techniques we cover. I will cover one or two problems in each lecture as an introduction, but you will need to work on the problem sets before the class. Bergstrom and Varians Workouts provide many additional exercises. Please let me know if there are any problems, or if anything can be done to improve the running of the course. Do come to me in the first instance.

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Introduction
Uncertainty is pervasive. Many of the choices we make include a element of risk. Economic theory can help us to understand the choices made in situations where there is risk. Examples:
Career choices Insurance markets Investments Gambling

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Topic objectives
To learn the language of expected utility theory. To understand risk aversion and risk-seeking. To consider examples where EUT provides insights
Insurance Investment

To consider the Ellsberg, Allais and St. Petersburg paradoxes.

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Reading
Varian, Chapter 12 Morgan, Katz and Rosen, Chapter 6

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The St. Petersburg Paradox (1/3)

How much would you pay to play the following lottery?
I will repeatedly toss a coin. If the first toss comes up tails, you win 2, and the game ends. If the first toss, is heads, we toss again. If the second toss is tails you win 4 and the game ends.
Otherwise we toss again.

If the third toss is tails you win 8. And so on (16, 32, 64)

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The St. Petersburg Paradox (2/3)

You have a probability of of getting 2.
You have a probability of = of getting 4. You have a probability of of getting 8. Etc. So your expected return in pounds is 2+ 4+ 8+=1+1+1+=
1 2 1 4 1 8 1 2 1 2 1 4 1 1 = 2 8 1 2 1 2 1 2

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The St. Petersburg Paradox (3/3)

So, lets play this game for real. One slight modification:
The most I will pay out is twice the amount you pay me for the right to play. So, if you pay me 10 for the right to play, the most I will pay out is 20 (so you double your money).

If I make a profit, the money will be donated to the Surrey Economic Society.

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The foundations of expected utility theory

The basis for EUT is the assumption that individuals are just as capable of making choices between uncertain consumption bundles as they are between certain bundles of goods.

This means that we can apply the tools of straight-forward consumer theory (budget constraints and indifference curves) to situations that involve uncertainty.

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The language of uncertainty

Generally uncertainty is discussed in terms of money as proxy for composite consumption. The consumption received depends on the outcome of a random event this is referred to as the STATE OF NATURE. We attach some probably to this. The CONTINGENT CONSUMPTION PLAN is a statement of the consumption that occurs in each state of nature.

For example:
The choice over whether or not to buy a lottery ticket. If I do not buy a lottery ticket my wealth will remain the same. If I buy a lottery ticket then I will lose 1 if none of my numbers come up and gain 1000000 if it is the winning ticket.

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Drawing the budget constraint

In straightforward consumer theory the budget constraint shows how much of good 1 you can trade for good 2. In EUT the budget constraint shows how much consumption in state of the world 1 you can trade for consumption in state of the world 2. A 1 bet on the turn of a card gives 40 if its not a heart.
You keep the 1 if you win and lose it if you lose.

Need to decide how much to bet.

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The budget constraint for a gamble

Consumption if not heart
Slope is 0.4 which is the cost of gaining 1 when a heart does appear in terms of loss when a heart does not appear.

0.4

Endowment

1
Budget constraint could be extended if the individual could offer the same bet to others

Consumption if heart
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But so we far we havent mentioned probability

We know that the chance of an individual winning the bet is 3 in 4. In which case we can work out the expected net value of the gamble: 0.4 0.75 + 1 0.25 = 0.30 0.25 = 0.05
The expected net value of this gamble is positive.

Would need to lower the prize slightly to generate a fair gamble.

If the prize was 33 the expected value would be: 0.33 0.75 + 1 0.25 = 0.25 0.25 = 0
The budget constraint for a fair gamble gives the fair-odds line. Draws a line between all the possible expected values.
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The fair-odds line

Consumption if not heart
We showed that the expected value of the gamble is zero when the payoff to not heart is 0.33.

0.33

Endowment

Consumption if heart
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Another example
In this case were gambling on the throw of a dice.
If its a six receive 4 times the stake (and keep the stake). Otherwise the stake is lost.

What would the budget constraint look like? Whats the expected value of the gamble? How would we need to change the game to make the gamble actuarially fair?

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The fair-odds line for the die game

5 = 6

Consumption if six

1 6 Slope= 5 1 = 5 Endowment 1

Consumption if not six

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In the general case

The fair odds line gives the slope of the budget constraint when the expected value is zero. The odds of an outcome occurring is the probability it occurs divided by the probability it does not occur.
I.e. 1 where is the probability of the event occurring. The odds of heart is 3 4 = 3. The odds of not six is 1 6 = 5. The fair odds line has slope given by minus the odds of the outcome on the horizontal axis. Why?!?
6 4 5

We generally put the worse outcome on the horizontal axis, but we need not. Notice that the actual budget constraint for the gamble and the fair-odds line need not be the same.
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Next: preferences
Choices are made over contingent commodities bundles of goods as represented by points on the budget line. The individual is not making a choice about the state of the world, of course they would prefer to win the gamble, but that choice isnt theirs to make. In the examples we have been considering the choice is over how much to gamble.

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The expected utility function

The utility function for consumption in states of the world 1 and 2 is 1 , 2 , 1
where 1 is consumption in state 1, 2 is consumption in state 2, 1 is the probability of state 1, 1 1 is the probability of state 2.

The utility of a contingent consumption plan depends on consumption in the two states of the world and the probability of each state of the world occurring. The expected utility form is: 1 , 2 , 1 = 1 1 + 1 1 2 Expected utility is a weighted average of the utility of the two possible consumptions with the weighting dependent on the probabilities.
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More on expected utility

The expected utility function is unique up to an affine transformation which means you can add a constant and multiply by a positive number and the preferences which result wont change.
Contrast with normal utility functions.

An expected utility function is also known as von-NeumannMorgenstern (vNM) utility function. Cobb-Douglas utility CD 1 , 2 , 1 = 1 1 2 1 is a vNM utility function, despite appearances, since: log CD 1 , 2 , 1 = 1 log 1 + 1 1 log 2
1

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Why does it make sense?

The additive nature of the expected utility function means that the utility derived from the consumption in each state of the world is independent of consumption in the other state of the world.

Once the state of the world is known you will only care about consumption in the SoW that prevails, the other will be irrelevant.
This is known as the independence axiom.

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Illustration of independence
Suppose utility is given by: 1 , 2 , 3 = 1 1 + 2 2 + 3 3
where 1 + 2 + 3 = 1.

Consider the MRS between consumption in state 1 and state 2:

MRS12 =
1 2

1 2

1 2

The MRS for consumption in SoW 1 and consumption in SoW 2 does not depend on what consumption is in SoW 3.

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Do you have vNM preferences? The Allais Paradox

Experiment 1 Experiment 2

Gamble 1A

Gamble 1B

Gamble 2A

Gamble 2B

Winnings
1

Chance
100%

Winnings
1 0

Chance
89% 1%

Winnings
0 1

Chance
89% 11%

Winnings
0

Chance
90%

10%

10%

Evidence for Prospect Theory??? Derived from: https://en.wikipedia.org/wiki/Allais_paradox

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Formal definition of the independence axiom

Suppose you prefer taking part in one gamble, A (e.g. the hearts one) to taking part in another, B (e.g. the dice one). And suppose C is a third gamble.

Then if I offer you a choice between the following two new gambles:
Gamble D: With probability , I run gamble A, and with probability 1 I run gamble C. Gamble E: With probability , I run gamble B, and with probability 1 I run gamble C.

Which do you prefer?

The independence axiom is the assumption that you will always prefer D here.

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Do you have vNM preferences? The Ellsberg Paradox

Suppose there is an urn containing:
33 red balls 66 balls that are a mix of black and yellow.
You do not know how many are black or how many are yellow.

Consider the following four gambles:

Gamble 1A: You receive 1 if you draw a red ball. Gamble 1B: You receive 1 if you draw a black ball. Gamble 2A: You receive 1 if you draw a red or a yellow ball. Gamble 2B: You receive 1 if you draw a black or a yellow ball.

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More on vMN preferences: An important distinction

Back to first example. Assume 10 bet. 0.75 chance of having 14, 0.25 chance of having 0. Therefore the expected value of the gamble is 10.50. The expected utility from the gamble is: 0.75 14 + 0.25 0
E.g. if = , this is 0.75 14 + 0.25 0 2.81

The utility from the expected value of a gamble is 10.5

E,g, if = , this is 10.5 3.24

Risk averse agents prefer to get the expected value of a gamble with certainty.

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Risk aversion
Utility
14
10.5 0.75 14 + 0.25 0

Notice that the expected utility of the gamble is lower than the utility of the expected value. I.e. 1 1 + 2 2 > 1 1 + 2 2 This is the definition of risk aversion.

10.5

14

consumption

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Risk loving
Utility
14

0.75 14 + 0.25 0 10.5

It is also possible to be risk loving, the opposite of risk aversion. This is preferring gambles over getting their expected value for certain. I.e. 1 1 + 2 2 < 1 1 + 2 2

What would risk neutral utility look like?

0 10.5 14

consumption

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Risk aversion and marginal utility

Notice that a risk averse utility function is concave.
There is a declining marginal utility of income.

Each extra 1 is worth less the richer you become.

As a consequence income lost has more impact than income gained. This is why a risk averse person would not want to take an actuarially fair gamble.

Empirical work suggests = log is a reasonable approximation to most peoples utility.

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Indifference curves with risk aversion

We would expect ICs to be convex: prefer a mix of consumption in both periods. This captures risk aversion. Certainty line

Consumption if not heart

45

Fair odds line (slope= 3) Consumption if heart appears

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Indifference curves with risk aversion

Risk aversion rules out indifference curves like the following one. Why?
Certainty line

Consumption if not heart

A B 45 Fair odds line (slope= 3) Consumption if heart appears

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Indifference curves with risk aversion

Point A and point B have the same expected return. But point A is a certainty. Therefore by the definition of risk aversion, A must be preferred. Indifference curves must be tangential to the fair odds line. A risk averse person always chooses equal consumption in both states of the world if offered fair odds.

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In equilibrium
Equilibrium follows exactly as it would in all other situations. The individual chooses the contingent consumption bundle which maximises his utility given the budget constraint he faces. So a risk averse consumer will not accept an actuarially fair gamble.

What will happen in the case of a risk lover?

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Risk premia
Utility
14
10.5 0.75 14 + 0.25 0

Risk premium is what youd need to be paid to be compensated for taking the risk. Its calculated as the difference between what youd be willing to pay for the gamble and its expected value.

0.75 14 + 0.25 0

10.5

14

consumption

Risk premium

Or with indifference curves

Fair odds line shows expected values. Would need to be compensated by the length of AB for being at A rather than B even though expected value is the same. Certainty line

B A Risk premium 45 A Fair odds line

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Example of optimisation (For next week perhaps)

Odds on Arsenal winning the premier league 10 to 1. You think their probability is 1 . You have 1000 to spend on consumption if you dont bet. Your von-Neumann-Morgenstern utility function is 1 1 + 1 1 2 How much should you bet? Suppose you bet .
Consumption if Arsenal win: 1 = 1000 + 10. Consumption if Arsenal lose: 2 = 1000 .

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Theoretical optimisation example (Certainly for next week)

Suppose that there are two possible future states of nature, 1 and 2, with probabilities 1 and 1 1 respectively. And suppose that there are two risky assets you can purchase.
Asset 1 pays out 1 in state 1 and 0 in state 2 and costs 1 . Asset 2 pays out 1 in state 2 and 0 in state 1 and costs 2 .

Expected (vNM) utility is 1 1 + 1 1 2 You have a wealth of to spend on 1 and 2 together.

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Coming up next time

More concrete applications of expected utility theory
Insurance Diversification in investment Decisions over criminal actions

Application of expected utility theory to moral philosophy!

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