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Chapter 7
Uncertainty andUncertainty andInformation
Nicholson and Snyder, Copyright ©2008 by Thomson South-Western. All rights reserved.
Mathematical Statistics• A random variable is a variable that
records, in numerical form, the possible outcomes from some random event
• The probability density function (PDF)shows the probabilities associated with pthe possible outcomes from a random variable
2
Mathematical Statistics• The expected value of a random variable
is the outcome that will occur “on average”
in
ii xfxXE
1
︶︵
dxxfxXE
︶︵
Mathematical Statistics• The variance and standard deviation
measure the dispersion of a random variable about its expected value
in
iix xfxEx
2
1
2
dxxfxExx
22
2xx
3
Expected Value
• Games which have an expected value ofGames which have an expected value of zero (or cost their expected values) are called fair games– a common observation is that people would
prefer not to play fair games
St. Petersburg Paradox• A coin is flipped until a head appearspp pp
• If a head appears on the nth flip, the player is paid $2n
x1 = $2, x2 = $4, x3 = $8,…,xn = $2n
• The probability of getting of getting aThe probability of getting of getting a head on the ith trial is (½)i
1=½, 2= ¼,…, n= 1/2n
4
St. Petersburg Paradox• The expected value of the St. Petersburg p g
paradox game is infinitei
i i
iii xXE
1 1 2
12)(
1111 ...)(XE )(
• Because no player would pay a lot to play this game, it is not worth its infinite expected value
Expected Utility• Individuals do not care directly about the y
dollar values of the prizes– they care about the utility that the dollars
provide
• If we assume diminishing marginal utility of wealth the St Petersburg game maywealth, the St. Petersburg game may converge to a finite expected utility value– this would measure how much the game is
worth to the individual
5
Expected Utility
• Expected utility can be calculated in theExpected utility can be calculated in the same manner as expected value
)()(1
n
iii xUXE
• Because utility may rise less rapidly than y y p ythe dollar value of the prizes, it is possible that expected utility will be less than the monetary expected value
The von Neumann-Morgenstern Theorem
• Suppose that there are n possible• Suppose that there are n possible prizes that an individual might win (x1,…xn) arranged in ascending order of desirability– x1 = least preferred prize U(x1) = 0
– xn = most preferred prize U(xn) = 1
6
The von Neumann-Morgenstern Theorem
• The point of the von Neumann• 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
The von Neumann-Morgenstern Theorem
• The von Neumann-Morgenstern methodThe von Neumann Morgenstern method is to define the utility of xi as the expected utility of the gamble that the individual considers equally desirable to xi
U( ) U( ) (1 ) U( )U(xi) = i · U(xn) + (1 - i) · U(x1)
7
The von Neumann-Morgenstern Theorem
• Since U(x ) = 1 and U(x ) = 0• Since U(xn) = 1 and U(x1) = 0
U(xi) = i · 1 + (1 - i) · 0 = i
• The utility number attached to any other prize is simply the probability of winning it
• Note that this choice of utility numbers is• Note that this choice of utility numbers is arbitrary
Expected Utility Maximization
• A rational individual will choose among• A rational individual will choose among gambles based on their expected utilities (the expected values of the von Neumann-Morgenstern utility index)
8
Expected Utility Maximization
• Consider two gambles:g– first gamble offers x2 with probability q and
x3 with probability (1-q)
expected utility (1) = q · U(x2) + (1-q) · U(x3)
– second gamble offers x5 with probability tand x6 with probability (1-t)
expected utility (2) = t · U(x5) + (1-t) · U(x6)
Expected Utility Maximization
• Substituting the utility index numbers g ygives
expected utility (1) = q · 2 + (1-q) · 3
expected utility (2) = t · 5 + (1-t) · 6
• The individual will prefer gamble 1 to p ggamble 2 if and only if
q · 2 + (1-q) · 3 > t · 5 + (1-t) · 6
9
Expected Utility Maximization
• If individuals obey the von Neumann• 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 N M ili i dNeumann-Morgenstern utility index
Risk Aversion• Two lotteries may have the same
expected value but differ in their riskiness– flip a coin for $1 versus $1,000
• Risk refers to the variability of the outcomes of some uncertain activity
• When faced with two gambles with the same expected value, individuals will usually choose the one with lower risk
10
Risk Aversion• In general, we assume that the marginal g , g
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 asa 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
Risk AversionUtility (U)
U(W) is a von Neumann-Morgensternutility index that reflects how the individualy ( )
U(W)
utility index that reflects how the individualfeels about each value of wealth
The curve is concave to reflect theti th t i l tilit
Wealth (W)
assumption that marginal utilitydiminishes as wealth increases
11
Risk AversionUtility (U)
Suppose that W* is the individual’s currentl l f i
y ( )
U(W)
level of income
U(W*) is the individual’scurrent level of utility
U(W*)
Wealth (W)W*
y
Risk Aversion
• Suppose that the person is offered two• Suppose that the person is offered two fair gambles:
– a 50-50 chance of winning or losing $h
Uh(W*) = ½ U(W* + h) + ½ U(W* - h)
50 50 h f i i l i $2h– a 50-50 chance of winning or losing $2h
U2h(W*) = ½ U(W* + 2h) + ½ U(W* - 2h)
12
Risk AversionUtility (U)
The expected value of gamble 1 is Uh(W*)y ( )
U(W)U(W*)Uh(W*)
Wealth (W)W* W* + hW* - h
Risk AversionUtility (U)
The expected value of gamble 2 is U2h(W*)y ( )
U(W)U(W*)
U2h(W*)
Wealth (W)W* W* + 2hW* - 2h
13
Risk AversionUtility (U) U(W*) > Uh(W*) > U2h(W*)y ( )
U(W)U(W*)
U(W ) U (W ) U (W )
U2h(W*)
Uh(W*)
Wealth (W)W* W* + 2hW* - 2h W* - h W* + h
Risk Aversion
• The person will prefer current wealth toThe person will prefer current wealth to that wealth combined with a fair gamble
• The person will also prefer a small gamble over a large one
14
Risk Aversion and Insurance
• The person might be willing to payThe person might be willing to pay some amount to avoid participating in a gamble
• This helps to explain why some individuals purchase insurance
Risk Aversion and insurance
Utility (U)W ” provides the same utility asparticipating in gamble 1y ( )
U(W)U(W*)Uh(W*) The individual will be
willing to pay up toW* - W ” to avoid
participating in gamble 1
Wealth (W)W*W* - h W* + h
participating in thegamble
W ”
15
Risk Aversion and Insurance
• An individual who always refuses fair• 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 g p y gbets
Willingness to Pay for Insurance
• Consider a person with a current wealthConsider a person with a current wealth of $100,000 who faces a 25% chance of losing his automobile worth $20,000
• Suppose also that the person’s von Neumann-Morgenstern utility index isg y
U(W) = ln (W)
16
Willingness to Pay for Insurance
• The person’s expected utility will beThe person s expected utility will beE(U) = 0.75U(100,000) + 0.25U(80,000)
E(U) = 0.75 ln(100,000) + 0.25 ln(80,000)
E(U) = 11.45714
• In this situation, a fair insurance premium would be $5,000 (25% of $20,000)
Willingness to Pay for Insurance
• The individual will likely be willing to pay• The individual will likely be willing to pay more than $5,000 to avoid the gamble. How much will he pay?
E(U) = U(100,000 - x) = ln(100,000 - x) = 11.45714
100,000 - x = e11.45714
x = 5,426
• The maximum premium is $5,426
17
Measuring Risk Aversion• The most commonly used risk aversion
measure was developed by Pratt
)('
)(" )(
WU
WUWr
• For risk averse individuals, U”(W) < 0– r(W) will be positive for risk averse
individuals
– r(W) is not affected by which von Neumann-Morganstern ordering is used
Measuring Risk Aversion
• The Pratt measure of risk aversion is• The Pratt measure of risk aversion is proportional to the amount an individual will pay to avoid a fair gamble
18
Measuring Risk Aversion• Let h be the winnings from a fair betLet h be the winnings from a fair bet
E(h) = 0
• Let p be the size of the insurance premium that would make the individual exactly indifferent between taking the fair bet h and paying p with certainty to avoid the gamble
E[U(W + h)] = U(W - p)
Measuring Risk Aversion• We now need to expand both sides ofWe now need to expand both sides of
the equation using Taylor’s series
• Because p is a fixed amount, we can use a simple linear approximation to the right-hand side
U(W - p) = U(W) - pU’(W) + higher order terms
19
Measuring Risk Aversion• For the left-hand side, we need to use a ,
quadratic approximation to allow for the variability of the gamble (h)
E[U(W + h)] = E[U(W) - hU’(W) + h2/2 U” (W)
+ higher order terms+ higher order terms
E[U(W + h)] = U(W) - E(h)U’(W) + E(h2)/2 U” (W)
+ higher order terms
Measuring Risk Aversion
• Remembering that E(h)=0 dropping the
)(")()(')( WkUWUWpUWU
• Remembering that E(h)=0, dropping the higher order terms, and substituting kfor E(h2)/2, we get
)()('
)(" Wkr
WU
WkUp
20
Risk Aversion and Wealth• 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 o e e , d s g a g a ut ty a somakes the gains from winning gambles less attractive
• the net result depends on the shape of the utility function
Risk Aversion and Wealth• If utility is quadratic in wealth
U(W) = a + bW + cW 2
where b > 0 and c < 0
• Pratt’s risk aversion measure is
cWU 2)("
cWb
c
WU
WUWr
2
2
)(
)( )(
• Risk aversion increases as wealth increases
21
Risk Aversion and Wealth• If utility is logarithmic in wealth
U(W) = ln (W )
where W > 0
• Pratt’s risk aversion measure is
WU 1)("
WWU
WUWr
1
)(
)(" )(
• Risk aversion decreases as wealth increases
Risk Aversion and Wealth• If utility is exponential
U(W) = -e-AW = -exp (-AW)
where A is a positive constant
• Pratt’s risk aversion measure is
eAWU AW2)("A
Ae
eA
WU
WUWr
AW
AW
2
)(
)(" )(
• Risk aversion is constant as wealth increases
22
Relative Risk Aversion
• It seems unlikely that the willingness to• It seems unlikely that the willingness to pay to avoid a gamble is independent of wealth
• A more appealing assumption may be that the willingness to pay is inversely proportional to wealth
Relative Risk Aversion
• This relative risk aversion formula is
)('
)(" )()(
WU
WUWWWrWrr
23
Relative Risk Aversion• The power utility function
U(W) = WR/R for R < 1, 0
exhibits diminishing absolute relative risk aversion
W
R
W
WR
WU
WUWr
R
R )1()1(
)('
)(")(
1
2
WWWU )(
but constant relative risk aversion
RRWWrWrr 1)1()()(
The Portfolio Problem
• How much wealth should a risk averse• How much wealth should a risk-averse person invest in a risky asset?– the fraction invested in risky assets should
be smaller for more risk-averse investors
24
The Portfolio Problem
• Assume an individual has wealth (W )• Assume an individual has wealth (W0) to invest in one of two assets– one asset yields a certain return of rf
– one asset’s return is a random variable, rr
The Portfolio Problem
• If k is the amount invested in the risky• If k is the amount invested in the risky asset, the person’s wealth at the end of one period will be
W = (W0 – k)(1 + rf) + k(1 + rr)
W = W (1 + r ) + k(r r )W = W0(1 + rf) + k(rr – rf)
25
The Portfolio Problem
• W is now a random variable• W is now a random variable– it depends on rr
• k can be positive or negative– can buy or sell short
• k can be greater than W0k can be greater than W0
– the investor could borrow at the risk-free rate
The Portfolio Problem• If we let U(W) represent this investor’sIf we let U(W) represent this investor s
utility function, the von Neumann-Morgenstern theorem states that he will choose k to maximize E[U(W)]
• The FOC is
0'10
frfrf rrUE
krrkrWUE
kWUE
26
The Portfolio Problem• As long as E(r – rf) > 0 an investorAs long as E(rr rf) > 0, an investor
will choose positive amounts of the risky asset
• As risk aversion increases, the amount of the risky asset held will fall
– the shape of the U’ function will change
The State-Preference Approach
• The approach taken in this chapter hasThe approach taken in this chapter has not used the basic model of utility-maximization subject to a budget constraint
• There is a need to develop new techniques to incorporate the standard choice-theoretic framework
27
States of the World• Outcomes of any random event can be y
categorized into a number of states of the world– “good times” or “bad times”
• Contingent commodities are goods d li d l if ti l t t f thdelivered only if a particular state of the world occurs– “$1 in good times” or “$1 in bad times”
States of the World• 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 sell for less than $1
28
Utility Analysis
• Assume that there are two contingentAssume that there are two contingent goods– wealth in good times (Wg) and wealth in bad
times (Wb)
– individual believes the probability that good times will occur is times will occur is
Utility Analysis
• The expected utility associated with theseThe expected utility associated with these two contingent goods is
V(Wg,Wb) = U(Wg) + (1 - )U(Wb)
• This is the value that the individual wants to maximize given his initial wealth (W)to maximize given his initial wealth (W)
29
Prices of Contingent Commodities
• Assume that the person can buy $1 of p y $wealth in good times for pg and $1 of wealth in bad times for pb
• His budget constraint isW = pgWg + pbWb
• The price ratio pg /pb shows how this person can trade dollars of wealth in good times for dollars in bad times
Fair Markets for Contingent Goods
• If markets for contingent wealth claims are well-developed and there is general agreement about , prices for these goods will be actuarially fair
pg = and pb = (1- )
• The price ratio will reflect the odds in favor• The price ratio will reflect the odds in favor of good times
1b
g
p
p
30
Risk Aversion• If contingent claims markets are fair, a g ,
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 occursoccurs
Risk Aversion• Maximization of utility subject to a budget
constraint requires that
b
g
b
g
b
g
p
p
WU
WU
WV
WVMRS
)(')1(
)('
/
/
• If markets for contingent claims are fair
1)('
)('
b
g
WU
WU
bg WW
31
Risk Aversion
Wb
The individual maximizes utility on thet i t li h W W
Since the market for contingentclaims is actuarially fair, thel f th b d t t i t 1
certainty line
Wb certainty line where Wg = Wb
slope of the budget constraint = -1
WgWg*
Wb*
U1
Risk Aversion
Wb
In this case, utility maximization may not occur on the certainty line
If the market for contingent
certainty line
Wb occur on the certainty line
gclaims is not fair, the slope ofthe budget line -1
Wg
U1
32
Insurance in the State-Preference Model
• Again consider a person with wealth ofAgain, consider a person with wealth of $100,000 who faces a 25% chance of losing his automobile worth $20,000– wealth with no theft (Wg) = $100,000 and
probability of no theft = 0.75
lth ith th ft (W ) $80 000 d– wealth with a theft (Wb) = $80,000 and probability of a theft = 0.25
Insurance in the State-Preference Model
• If we assume logarithmic utility then• If we assume logarithmic utility, then
E(U) = 0.75U(Wg) + 0.25U(Wb)
E(U) = 0.75 ln Wg + 0.25 ln Wb
E(U) = 0.75 ln (100,000) + 0.25 ln (80,000)
E(U) = 11.45714
33
Insurance in the State-Preference Model
• The budget constraint is written in terms ofThe budget constraint is written in terms of the prices of the contingent commodities
pgWg* + pbWb* = pgWg + pbWb
• Assuming that these prices equal the probabilities of these two states
0.75(100,000) + 0.25(80,000) = 95,000
• The expected value of wealth = $95,000
Insurance in the State-Preference Model
• The individual will move to the certainty lineThe individual will move to the certainty line and receive an expected utility of
E(U) = ln 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 timesinto $15,000 of extra wealth in bad times
• a fair insurance contract will allow this
• the wealth changes promised by insurance (dWb/dWg) = 15,000/-5,000 = -3
34
A Policy with a Deductible• 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
E(U) = 0 75 ln 95 100 + 0 25 ln 94 100E(U) 0.75 ln 95,100 + 0.25 ln 94,100
E(U) = 11.46004
• The policy still provides higher utility than doing nothing
Risk Aversion and Risk Premiums
• Consider two people, each of whom p p ,starts with an initial wealth of W*
• Each seeks to maximize an expected utility function of the form
WWWWV
Rb
Rg )()( 1
RRWWV bg
bg )(),( 1
• This utility function exhibits constant relative risk aversion
35
Risk Aversion and Risk Premiums
WWWWV
Rb
Rg )()( 1
RRWWV bg
bg )(),( 1
• The parameter R determines both the degree of risk aversion and the degree of curvature of indifference curves implied bycurvature of indifference curves implied by the function– a very risk averse individual will have a large
negative value for R
A very risk averse person will have sharply curved
Risk Aversion and Risk Premiums
Wb
A person with more tolerance for risk will have flatter indifference curves such as U2
A very risk averse person will have sharply curvedindifference curves such as U1
certainty line
Wb
W*
U2
U1
WgW*
W
36
Suppose that individuals are faced with losing h
Risk Aversion and Risk Premiums
Wbpp g
dollars in bad times
certainty line
Wb
W*
The difference between W1
and W2 shows the effect of risk aversion on thewillingness to accept risk
U2
U1
WgW*
W willingness to accept riskW* - h
W2 W1
Properties of Information• Information is not easy to definey
– difficult to measure the quantity of information obtainable from different actions
– too many forms of useful information to permit the standard price-quantitypermit the standard price quantity characterization used in supply and demand analysis
37
Properties of Information
• Studying information also becomesStudying information also becomes difficult due to some technical properties of information– it is durable and retains value after its use
– it can be nonrival and nonexclusive• in this manner it can be considered a public
good
The Value of Information• Lack of information represents a problem p p
involving uncertainty for a decision maker– the individual may not know exactly what the
consequences of a particular action will be
• Better information can reduce uncertainty and lead to better decisions and higherand lead to better decisions and higher utility
38
The Value of Information• Assume an individual forms subjective j
opinions about the probabilities of two states of the world– “good times” (probability = g) and “bad
times” (probability = b)
I f ti i l bl b it h l• Information is valuable because it helps the individual revise his estimates of these probabilities
The Value of Information
• Assume that information can be• Assume that information can be measured by the number of “messages” (m) purchased– these messages can take on a value of 1
(with a probability of p) or 2 (with a b bilit f (1 )probability of (1 – p)
39
The Value of Information
• If the message takes the value of 1 the• If the message takes the value of 1, the person believes the probability of good times is 1
g so 1b = 1 - 1
g
• If the message takes the value of 2, the person believes the probability of goodperson believes the probability of good times is 2
g so 2b = 1 - 2
g
The Value of Information
• Let V = indirect maximal utility when the• Let V1 = indirect maximal utility when the message =1
• Let V2 = indirect maximal utility when the message =2
• The expected utility is thene e pec ed u y s eEwith m = pV1 + (1 – p)V2
40
The Value of Information
• What if the person does not purchase the• What if the person does not purchase the message?
• Let V0 = indirect maximal utility without the message
• Now, expected utility will beo , e pec ed u y beEwithout m = V0 = pV0 + (1 – p)V0
The Value of Information
• Therefore information has value as long• Therefore, information has value as long as
Ewith m > Ewithout m
41
The Value of Information on Prices
• In chapter 4 we learned that is an• In chapter 4, we learned that is an individual has a utility function of U(x,y) = x0.5y0.5, the indirect utility function is
5.05.02︶,,︵ yx pp
ppV II
2 yx pp
The Value of Information on Prices
• If p = 1 p = 4 and I = 8 then V = 2• If px = 1, py = 4, and I = 8, then V = 2
• Suppose that y is a can of brand-name tennis balls– can be found at a price of $3 or $5 fromcan be found at a price of $3 or $5 from
two stores• the consumer does not know which store
charges which price
42
The Value of Information on Prices
• Before shopping expected utility is• Before shopping, expected utility is
8,5,15.08,3,15.0︶,,︵ VVppVE yx I
049.2894.0155.1︶,,︵ Iyx ppVE
The Value of Information on Prices
• To calculate the value of information• To calculate the value of information, we solve the equation
049.23122︶
,,︵ 5.05.05.0
*
pp*ppV
yxyx
III
• Solving this yields I* = 7.098– the information is worth 8 – 7.098 = 0.902
43
Flexibility and Option Value
• It may be beneficial to postpone• It may be beneficial to postpone decisions until information is available– but this type of flexibility may involve costs
of its own• may have to give up interest on investments if
the investor waits to make his portfolio decisionthe investor waits to make his portfolio decision
• financial options add flexibility to this type of decision making
Asymmetry of Information
• The level of information that a person buysThe level of information that a person buys will depend on the price per unit
• Information costs may differ significantly across individuals– some may possess specific skills for acquiring
information
– some may have experience that is relevant
– some may have made different former investments in information services
44
Important Points to Note:• The most common way to model
behavior under uncertainty is to assume that individuals seek to maximize the expected utility of their options
Important Points to Note:
• Individuals who exhibit diminishingIndividuals who exhibit diminishing marginal utility of wealth are risk averse– they generally refuse fair bets
45
Important Points to Note:• Risk averse individuals will wish to
insure themselves completely against uncertain events if insurance premiums are actuarially fair– they may be willing to pay more than
actuarially fair premiums to avoid takingactuarially fair premiums to avoid taking risks
Important Points to Note:• Two utility functions have been y
extensively used in the study of behavior under uncertainty– the constant absolute risk aversion
(CARA) function
the constant relative risk aversion– the constant relative risk aversion (CRRA) function
46
Important Points to Note:• One of the most extensively studied y
issues in the economics of uncertainty is the “portfolio problem”– asks how an investor will split his wealth
between risky and risk-free assets
in some cases it is possible to obtain– in some cases, it is possible to obtain precise solutions to this problem
• depends on the nature of the risky assets that are available
Important Points to Note:• The state-preference approach allows p pp
decision making under uncertainty to be approached in a familiar choice-theoretic framework– especially useful for looking at issues that
arise in the economics of informationarise in the economics of information
47
Important Points to Note:• Information is valuable because it
permits individuals to make better decisions in uncertain situations– information can be most valuable when
individuals have some flexibility in their decision makingdecision making