Econ 310: Decision Making Under Uncertainty

Sumon Majumdar

Sumon Majumdar ()

Uncertainty

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Decisions under uncertainty

Principal element:
Lottery: can win prize x with prob. p or prize y with prob. 1
i.e. can get utility u (x ) with prob. p or u (y ) with prob. 1

Overall utility from this lottery:

pu (x ) + (1

Sumon Majumdar ()

p )u (y )

Uncertainty

Expected utility

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Decisions under uncertainty

Principal element:
Lottery: can win prize x with prob. p or prize y with prob. 1
i.e. can get utility u (x ) with prob. p or u (y ) with prob. 1

Overall utility from this lottery:

pu (x ) + (1

p )u (y )

Expected utility

More general: prize x1 with prob. p1 , ...., xn with prob. pn

p1 u (x1 ) + p2 u (x2 ) + ....... + pn u (xn )

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Uncertainty

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Decisions under uncertainty

Even more general:

e is a random variable with the density function f (x )
X
Expected utility:

u (x )f (x )dx

example: uniform distribution over [10, 100]. Density =

1
90

Suppose u (x ) = x 1/2 . Expected utility:

Z 100
10

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x 1/2

1
dx =?
90

Uncertainty

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Decisions under uncertainty applications: Insurance

Individual has wealth w , but faces prospect of a loss L

prob. of incurring loss = p
Insurance co.: for $1 of coverage need to pay premium
Individual chooses i to max:

F.O.C. :

Sumon Majumdar ()

pu (w L + i i ) + (1 p )u (w i )
u 0 (w L + i i )
1 p
=
0
u (w i )
p 1

Uncertainty

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Decisions under uncertainty applications: Insurance

Individual has wealth w , but faces prospect of a loss L

prob. of incurring loss = p
Insurance co.: for $1 of coverage need to pay premium
Individual chooses i to max:

F.O.C. :

pu (w L + i i ) + (1 p )u (w i )
u 0 (w L + i i )
1 p
=
0
u (w i )
p 1

Actuarially fair insurance: = p ) i = L

Sumon Majumdar ()

Uncertainty

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Decisions under uncertainty applications: Insurance

Individual has wealth w , but faces prospect of a loss L

prob. of incurring loss = p
Insurance co.: for $1 of coverage need to pay premium
Individual chooses i to max:

F.O.C. :

pu (w L + i i ) + (1 p )u (w i )
u 0 (w L + i i )
1 p
=
0
u (w i )
p 1

Actuarially fair insurance: = p ) i = L

Usually: > p ) i < L

Sumon Majumdar ()

Uncertainty

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Decisions under uncertainty applications: Investing in a

Risky Asset
Individual has wealth w , can invest in a risky asset
e
rate of return on risky asset: R
If invests amount a in risky asset, then wealth
w
e = (w

e ) = w + aR
e
a ) + a (1 + R

e)
Individual chooses a to max: Eu (w + aR

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Uncertainty

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Decisions under uncertainty applications: Investing in a

Risky Asset
Individual has wealth w , can invest in a risky asset
e
rate of return on risky asset: R
If invests amount a in risky asset, then wealth
w
e = (w

e ) = w + aR
e
a ) + a (1 + R

e)
Individual chooses a to max: Eu (w + aR
When u (x ) = Gx

max Gw
a

Sumon Majumdar ()

Hx 2 , this becomes:
Hw 2 + (G

2Hw )a

Uncertainty

Ha2 (2 + 2 )

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Decisions under uncertainty applications: Investing in a

Risky Asset
Individual has wealth w , can invest in a risky asset
e
rate of return on risky asset: R
If invests amount a in risky asset, then wealth
w
e = (w

e ) = w + aR
e
a ) + a (1 + R

e)
Individual chooses a to max: Eu (w + aR
When u (x ) = Gx

max Gw
a

which implies a =
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Hx 2 , this becomes:
Hw 2 + (G

2Hw )a

Ha2 (2 + 2 )

G 2Hw
2H (2 +2 )

Uncertainty

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Decisions under uncertainty applications: Precautionary

Savings

Individual has a job today with salary I

But with prob. q, may lose the job tomorrow
How much should he save?

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Uncertainty

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Decisions under uncertainty applications: Precautionary

Savings

Individual has a job today with salary I

But with prob. q, may lose the job tomorrow
How much should he save?
utility function u (w ) = ln(w ) :
max ln(I
s

Sumon Majumdar ()

s ) + q ln(s ) + (1

Uncertainty

q ) ln(I + s )

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Decisions under uncertainty applications: Precautionary

Savings

Individual has a job today with salary I

But with prob. q, may lose the job tomorrow
How much should he save?
utility function u (w ) = ln(w ) :
max ln(I
s

s ) + q ln(s ) + (1

q ) ln(I + s )

FOC wrt s : ? ) s?

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Uncertainty

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Decisions under uncertainty: Risk Aversion

pu (x ) + (1
concave

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p )u (y ) < u (px + (1

Uncertainty

p )y ) : Risk averse

u is

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Decisions under uncertainty: Risk Aversion

pu (x ) + (1
concave

p )u (y ) < u (px + (1

p )y ) : Risk averse

pu (x ) + (1
linear

p )u (y ) = u (px + (1

p )y ) : Risk neutral

Sumon Majumdar ()

Uncertainty

u is

u is

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Decisions under uncertainty: Risk Aversion

pu (x ) + (1
concave

p )u (y ) < u (px + (1

p )y ) : Risk averse

pu (x ) + (1
linear

p )u (y ) = u (px + (1

p )y ) : Risk neutral

pu (x ) + (1
convex

p )u (y ) > u (px + (1

p )y ) : Risk loving

Sumon Majumdar ()

Uncertainty

u is

u is

u is

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Decisions under uncertainty: How Risk Averse?

Certainty equivalent: pu (x ) + (1

Sumon Majumdar ()

Uncertainty

p )u (y ) = u (CE )

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Decisions under uncertainty: How Risk Averse?

Certainty equivalent: pu (x ) + (1
Risk premium: pu (x ) + (1

Sumon Majumdar ()

p )u (y ) = u (CE )

p )u (y ) = u [px + (1

Uncertainty

p )y

RP ]

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Decisions under uncertainty: How Risk Averse?

Certainty equivalent: pu (x ) + (1
Risk premium: pu (x ) + (1
CE = px + (1

Sumon Majumdar ()

p )y

p )u (y ) = u (CE )

p )u (y ) = u [px + (1

p )y

RP ]

RP

Uncertainty

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Decisions under uncertainty: How Risk Averse?

Certainty equivalent: pu (x ) + (1
Risk premium: pu (x ) + (1
CE = px + (1

p )y

p )u (y ) = u (CE )

p )u (y ) = u [px + (1

RP ]

RP

Arrow-Pratt measure of absolute risk aversion:

Sumon Majumdar ()

p )y

Uncertainty

u 00 (x )
u 0 (x )

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Decisions under uncertainty: How Risk Averse?

Certainty equivalent: pu (x ) + (1
Risk premium: pu (x ) + (1
CE = px + (1

p )y

p )u (y ) = u (CE )

p )u (y ) = u [px + (1

RP ]

RP

Arrow-Pratt measure of absolute risk aversion:

Measure of relative risk aversion:

Sumon Majumdar ()

p )y

Uncertainty

u 00 (x )
u 0 (x )

u 00 (x )x
u 0 (x )

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