Decisions under

Uncertainty

Topic 18
Decisions under Risk

Probabilities and
Expected Utility
The Allais Paradox
Attitudes Towards
Risk
Insurance and
Investment

Textbook: Chapter 16 (all editions)

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Decisions under
Uncertainty

Probabilities and
Expected Utility

Probabilities and Expected Utility

The Allais Paradox

Attitudes Towards
Risk

The Allais Paradox

Insurance and
Investment

Attitudes Towards Risk

Insurance and Investment

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Probabilities and Expected Utility

Examples of decisions under uncertainty:
I

Should I walk or should I drive to work?

Which medical treatment should I seek?

To which side of the goal should I kick the soccer ball?

Which stocks should I buy?

Which health insurance should I buy?

Should I drop out of Econ 401 or stay?

Decisions under
Uncertainty

Probabilities and
Expected Utility
The Allais Paradox
Attitudes Towards
Risk
Insurance and
Investment

The theory of rational decisions under uncertainty:

The theory of expected utility maximization.

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Rational Decisions under Uncertainty

Make a list of the available choices:
I

Walk to work.

Drive to work.

Decisions under
Uncertainty

Probabilities and
Expected Utility
The Allais Paradox
Attitudes Towards
Risk
Insurance and
Investment

Make a list of mutually exclusive outcomes:

I

You may arrive on time.

You may arrive late, but have no accident.

You may arrive late, and have an accident.

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Decisions under
Uncertainty

Probabilities and Utilities

Probabilities:
Outcome

Probabilities and
Expected Utility

on time

late/no accident

late/accident

The Allais Paradox

Action walk to work

0.8

0.2

Attitudes Towards
Risk

drive to work

0.95

0.04

0.01

Insurance and
Investment

Utilities:
on time

late/no accident

late/accident

0.7

-5

Choose action with the highest expected utility:

Expected utility from walk to work:
0.8 1 + 0.2 0.7 + 0 ( 5) = 0.94.
Expected utility from drive to work:
0.95 1 + 0.04 0.7 + 0.01 ( 5) = 0.928.

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Decisions under
Uncertainty

Recap
1. Make a list of the available actions.

Probabilities and
Expected Utility

2. Make a list of mutually exclusive outcomes.

The Allais Paradox

3. For each choice determine the probability of each

outcome.

Attitudes Towards
Risk
Insurance and
Investment

Probabilities between 0 and 1; add up to 1.

4. Assign utility to each outcome.
5. Choose the action with the highest expected utility.
Expected utility
= sum of (probability of outcome utility of outcome).
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Decisions under
Uncertainty

The Allais Paradox

You can choose among two lottery tickets:

Probabilities and
Expected Utility
The Allais Paradox
Attitudes Towards
Risk

Ticket 1

Ticket 2

$10 m

$5 m

$0

0%

100%

0%

$10 m

$5 m

$0

10%

89%

1%

Insurance and
Investment

What would you choose? ...Most people choose ticket 1.

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Decisions under
Uncertainty

The Allais Paradox

Then you can choose among two other lottery tickets:

Probabilities and
Expected Utility
The Allais Paradox
Attitudes Towards
Risk

Ticket 3

Ticket 4

$10 m

$5 m

$0

0%

11%

89%

$10 m

$5 m

$0

10%

0%

90%

Insurance and
Investment

What would you choose?... Most people choose ticket 4.

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Decisions under
Uncertainty

The Allais Paradox

Probabilities and
Expected Utility

But these choices are inconsistent with expected utility

maximization:
EU from ticket 1 > EU from ticket 2 ,

The Allais Paradox

Attitudes Towards
Risk
Insurance and
Investment

u(5) > 0.1u(10) + 0.89u(5) + 0.01u(0) ,

0.11u(5) > 0.1u(10) + 0.01u(0).

EU from ticket 4 > EU from ticket 3 ,

0.1u(10) + 0.9u(0) > 0.11u(5) + 0.89u(0) ,

0.1u(10) + 0.01u(0) > 0.11u(5).

I

Contradiction

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Decisions under
Uncertainty

The Allais Paradox

Probabilities and
Expected Utility
The Allais Paradox
Attitudes Towards
Risk

Ticket 1

0.11

0.89

$5 m

$5 m

Ticket 2

0.11

Insurance and
Investment

0.89
$5 m

10/11

1/11

$10 m $0

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Decisions under
Uncertainty

The Allais Paradox

Probabilities and
Expected Utility
The Allais Paradox
Attitudes Towards
Risk

Ticket 3

Ticket 4

0.11

0.89

$5 m

$0

0.11

Insurance and
Investment

0.89
$0

10/11

1/11

$10 m $0

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Decisions under
Uncertainty

The Allais Paradox

Probabilities and
Expected Utility

All that matters for your choice is whether you prefer:

I
I

$5 m with certainty;
$10 m with probability

10
11

and $0 with probability

1
11 .

The Allais Paradox

Attitudes Towards
Risk
Insurance and
Investment

You should make the same choice in both cases.

The Independence axiom (informally):

Your preference among lotteries should not depend
on parts of the lottery that you cannot aect.

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Von Neumann Morgenstern Utility

von Neumann and Morgenstern have a system of axioms for
preferences over lotteries with known probabilities.
The Independence Axiom is their most important axiom.
The axioms are equivalent to the hypothesis that preferences
can be represented as expected utility maximization.

Decisions under
Uncertainty

Probabilities and
Expected Utility
The Allais Paradox
Attitudes Towards
Risk
Insurance and
Investment

The utility function u is also called

I

von Neumann Morgenstern utility function;

Bernoulli utility function.

The utility function is unique up to increasing linear

transformations:
v (x) = a + bu(x) where b > 0 ) v and u reflect the same
preferences.
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Utility of Money

Decisions under
Uncertainty

Probabilities and
Expected Utility
The Allais Paradox

Special case: outcomes are money payments x.

Attitudes Towards
Risk
Insurance and
Investment

Lotteries are probability distributions over money payments.

The decision maker has a utility function u(x).
When choosing among lotteries, the decision maker chooses
the one that maximizes expected utility.

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Attitudes Towards Risk

Suppose we ask a decision maker to choose between:
I

getting the lottery:

x1 with probability p1 , x2 with probability p2 , . . .

getting the expected value

Decisions under
Uncertainty

Probabilities and
Expected Utility
The Allais Paradox
Attitudes Towards
Risk
Insurance and
Investment

x1 p1 + x2 p2 + . . . with probability 1.
The decision maker is:
I

risk averse if she always prefers the expected value over

the lottery;

risk neutral if she is always indierent between the

expected value and the lottery;

risk preferring if she always prefers the lottery over the

expected value.
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Attitudes Towards Risk

Decisions under
Uncertainty

Probabilities and
Expected Utility
The Allais Paradox

How can we tell the decision makers attitude towards risk

by looking only at his utility function u?

Attitudes Towards
Risk
Insurance and
Investment

Result:
The decision maker is:
I

risk averse if and only if u is concave: d 2 u/(dx)2 < 0;

risk neutral if and only if u is linear: d 2 u/(dx)2 = 0;

risk preferring if and only if u is convex: d 2 u/(dx)2 > 0.

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Decisions under
Uncertainty

20

Utility Functions

Probabilities and
Expected Utility

15

concave

The Allais Paradox

linear

Attitudes Towards
Risk

10

Insurance and
Investment

convex

10

15

x
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Decisions under
Uncertainty

Concavity and Risk Aversion

Probabilities and
Expected Utility
The Allais Paradox
Attitudes Towards
Risk
Insurance and
Investment

u(p1x1+p2x2)
p1u(x1)+p2u(x2)

x1 p1x1+p2x2

x2

x
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Decisions under
Uncertainty

The Risk Premium

Probabilities and
Expected Utility

How much would you pay to avoid taking a risk?

Suppose the decision maker chooses between
I

The Allais Paradox

Attitudes Towards
Risk
Insurance and
Investment

getting the lottery:

x1 with probability p1 , x2 with probability p2 , . . .

getting the expected value minus

x 1 p 1 + x2 p 2 + . . .

with probability 1.

We call the value of that makes the decision maker

indierent the risk premium.

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Attitudes Towards Risk

Suppose u is strictly increasing.

Decisions under
Uncertainty

Probabilities and
Expected Utility
The Allais Paradox
Attitudes Towards
Risk

For risk averse decision makers:

I

the risk premium is positive.

Insurance and
Investment

For risk neutral decision makers:

I

the risk premium is zero.

For risk preferring decision makers:

I

the risk premium is negative.

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Decisions under
Uncertainty

The Risk Premium

The length of the red line is the risk premium.

Probabilities and
Expected Utility
The Allais Paradox
Attitudes Towards
Risk
Insurance and
Investment

u(p1x1+p2x2)
p1u(x1)+p2u(x2)

x1 p1x1+p2x2

x2

x
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Decisions under
Uncertainty

Example

Probabilities and
Expected Utility

U(x) =

The Allais Paradox

Attitudes Towards
Risk

$1 with probability 0.5, $4 with probability 0.5.

Insurance and
Investment

The risk premium solves:

p
p
p
0.5 1 + 0.5 4 =
0.5 1 + 0.5 4
p
1.5 =
2.5 ,
2.25 = 2.5

= 0.25

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Decisions under
Uncertainty

Comparing Risk Attitudes

Probabilities and
Expected Utility
The Allais Paradox

Consider two individuals with von Neumann Morgenstern

utility functions u and v .

Attitudes Towards
Risk
Insurance and
Investment

Definition
The utility function u is more risk averse than v if for every
lottery the risk premium under u is at least as large as the
risk premium under v .

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Decisions under
Uncertainty

Comparing Risk Attitudes

The Arrow-Pratt measure of risk aversion:

Probabilities and
Expected Utility
The Allais Paradox

u 00 (x)

Attitudes Towards
Risk

u 0 (x)

Insurance and
Investment

Suppose v (x) = au(x) + b.

Then
v 0 (x) = au 0 (x)
v 00 (x) = au 00 (x)
v 00 (x)
au 00 (x)
=
=
v 0 (x)
au 0 (x)

u 00 (x)
u 0 (x)

) The Arrow-Pratt measure of risk aversion is not aected

by linear transformations.
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Decisions under
Uncertainty

Comparing Risk Attitudes

Probabilities and
Expected Utility
The Allais Paradox
Attitudes Towards
Risk

Result:
u is more risk averse than v if and only if for every x the
Arrow-Pratt measure of risk aversion is at least as large for u
as for v .

Insurance and
Investment

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Decisions under
Uncertainty

Insurance

Probabilities and
Expected Utility

A risk averse decision maker: u(x) =

x.

You face the 10% risk that your house burns down:
Wealth if the house stands: $100 (probability: 0.9).

The Allais Paradox

Attitudes Towards
Risk
Insurance and
Investment

Wealth if the house burns down: $20 (probability: 0.1).

Insurance:
I

If your house burns down, you get $x.

If your house does not burn down, you get $0.

Fair insurance: premium=$0.1x.

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Decisions under
Uncertainty

Expected Utility Maximizing Insurance

How much insurance should you buy to maximize expected utility?
u(x)

=
=

0.9 100
p
0.9 100

p
0.1x + 0.1 20 0.1x + x
p
0.1x + 0.1 20 + 0.9x

First Order Condition:

du
dx
1
1
0.9 p
( 0.1) + 0.1 p
0.9
2 100 0.1x
2 20 + 0.9x
0.09
p
2 100 0.1x
100 0.1x
x

Probabilities and
Expected Utility
The Allais Paradox
Attitudes Towards
Risk
Insurance and
Investment

0,

0,

=
=
=

0.09
p
2 20 + 0.9x
20 + 0.9x ,
80

Full insurance:
Equal wealth in both states: 100

0.1 80 = 20 + 0.9 80

Insurance and Investment

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Decisions under
Uncertainty

Probabilities and
Expected Utility
The Allais Paradox
Attitudes Towards
Risk

Risk averse decision makers

I

buy full insurance when oered insurance at fair odds;

buy at least a small amount of any investment with

positive expected return.

Insurance and
Investment

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