1. Introductory Microeconomics (ES10001) Topic 3: Risk and Uncertainty

2. 1.Introduction We have so far assumed that the world is certain This is a a (very) strong assumtion This world is inherently uncertain The same people who insure their cars and houses also but lottery tickets and play bingo! Why?

3. 2.Uncertainty Assume that there are two states of the world State 1:Wealth = w 1 State 2:Wealth = w 2 = w 1 - L where L > 0 occurs with probability p > 0 Expected wealth:

4. 2. Risk and Uncertainty Expected wealth:

5. 2.Risk and Uncertainty Individuals are not interested in wealth per se, but in the utility of wealth This is an important distinction; an increase in wealth of £100 is unlikely to change the utility of a prince (David Beckham?) and a pauper (me!) by the same amount Assume individual’s utility function is u = u(w) Individual’s objective is to maximise expected utility, not expected wealth!

6. 2.Risk and Uncertainty Utility function: We assume that total utility increases with wealth such that marginal utility is positive:

7. 2.Risk and Uncertainty Expected Utility: Add and subtract u(w 2 )

8. 2. Risk and Uncertainty Multiply and divide second term by (w 1 – w 2 )

9. 2. Risk and Uncertainty Consider final term (1- p)(w 1 – w 2 )

10. 2.Risk and Uncertainty Thus:

11. 2. Risk and Uncertainty This is the equation of a straight line! Consider the following:

12. w u(w)u(w) 0 u(w)u(w) Figure 1: Risk Averseness

13. w u(w)u(w) 0 u(w)u(w) A D

14. w u(w)u(w) 0 u(w)u(w) A D C

15. w u(w)u(w) 0 u(w)u(w) A D

16. w u(w)u(w) 0 u(w)u(w) A D

17. w u(w)u(w) 0 u(w)u(w) A D

18. w u(w)u(w) 0 u(w)u(w) A D

19. w u(w)u(w) 0 u(w)u(w) A D

20. w u(w)u(w) 0 u(w)u(w) A D E

21. w u(w)u(w) 0 u(w)u(w) A D E

22. w u(w)u(w) 0 u(w)u(w) A D E

23. 2. Uncertainty Note that expected utility,, is equal to the utility of wealth with certainty 1.e.

24. w u(w)u(w) 0 u(w)u(w) A D Figure 1: Risk Averseness

25. w u(w)u(w) 0 u(w)u(w) A D E

26. w u(w)u(w) 0 u(w)u(w) A D E B

27. 2. Risk and Uncertainty We define as individual’s certainty equivalent level of wealth That is, the level of wealth that allows individual the same utility as he could expect if he faces a (1 - p) chance of w 1 and a p chance of w 2 Thus, is the maximum premium the individual would be prepared to pay for insurance

28. w u(w)u(w) 0 u(w)u(w) A E D B C Figure 1: Risk Averseness

29. w u(w)u(w) 0 u(w)u(w) A E D B C r max Figure 1: Risk Averseness

30. 2. Risk and Uncertainty Under an insurance contract, θ = (r, L), the individual pays’ a premium, r (in both states of the world) and in return the insurance company contracts to reimburse the individual should he suffer the state 2 loss, L. Thus, individual's state contingent wealth under an insurance contract is: State 1: State 2:

31. 2. Risk and Uncertainty If insurance company agrees to compensate individual, then it can expect to face costs of: Thus, r min, the minimum premium the insurance company would be prepared to accept, is given by:

32. 2. Risk and Uncertainty

33. w u(w)u(w) 0 u(w)u(w) A E D B C Figure 1: Risk Averseness

34. w u(w)u(w) 0 u(w)u(w) A E D B C r min

35. w u(w)u(w) 0 u(w)u(w) r max A E D B C Figure 1: Risk Averseness

36. w u(w)u(w) 0 u(w)u(w) A E D B C The Market for Insurance Figure 1: Risk Averseness r max r min

37. w u(w)u(w) 0 u(w)u(w) A E D B C The Market for Insurance Figure 1: Risk Averseness

38. 2. Risk and Uncertainty Note that: Since, there is a Pareto-improving market for insurance; i.e. because the individual’s utility function is concave, he is willing to pay to insure against risk. Such an individual is said to be risk averse

39. 2. Risk and Uncertainty N.B. Change in marginal utility with respect to wealth (second derivative): (1)Risk Averse: (2)Risk Neutral: (3)Risk Loving:

40. 2. Risk and Uncertainty In words: Risk averse individuals are prepared to pay a premium to avoid risk: Risk neutral individuals are indifferent to paying a premium and not paying a premium to avoid risk. Risk loving individuals are prepared to pay a premium to take risk

41. w u(w)u(w) 0 w 2 w 1 u(w)u(w) Figure 2: Risk Neutral r min = r max

42. w u(w)u(w) 0 w 2 w 1 u(w)u(w) Figure 3: Risk Loving r min r max