Information & Uncertainty

Choice with uncertainty

Von NeumannMorgenstern
utility function
Risk aversion
Uncertainty vs Information
p The classical model of consumer choice is totally deterministic and based
on the hypothesis of perfect information.

p The economic agents have complete information about the characteristics

of the goods and other parameters affecting their choice. They can
anticipate all the consequences of their decisions.

p Perfect information is a very strong hypothesis: it implies that the cost of

information is zero, what is never true.

p As long as information has a positive cost, the decision maker will seek a
optimal level of information, weighting expected cost and benefit, but
rarely attaining perfect information.
Uncertainty vs Information
p On the other hand, some of the choice parameters have an intrinsic
stochastic component (what is our life expectancy, how will the
weather be in a week, what will the euro/dollar exchange rate be in a
month) or are non accessible private information (what is the cost
function of our competitors or suppliers, what is the degree of ware in
an used Porsche).

p Hence, most of our decisions must be made in an uncertain context.

p Uncertainty is the inverse of information; the more information we

have the less uncertainty we face (ex: eclipses, hurricane forecasting,
etc.).
Uncertainty
p Economic agents face the choice among stochastic, i.e., non deterministic,
alternatives. The subject of their decision may be what we call a lottery.

p A lottery is a ordered set of several possible results (x1,x2,x3), each result with
an associated probability (p1,p2,p3). A lottery will be denoted as

L = [(p1,x1),(p2,x2),(p3,x3)]

p To simplify, we will assume that each lottery has only two possible results
(x,y), with probabilities (p, (1-p)), i.e., [(p,x),((1-p),y)] .

p As a matter of fact, y can also be a lottery, with outcomes (w,z) and

probabilities (t, (1-t)). Hence, we end up with 3 results (x,w,z) with
probabilities (p,(1-p)t, (1-p)(1-t)). And so on.
Uncertainty
p Consumers must now have a system of preferences over all possible
decisions they may choose, be them deterministic or lotteries. This
system of preferences should satisfy the usual hypothesis, guarantying
the existence of an utility function representing this system of
preferences, i.e., such as:

A } B => U(A) > U(B)

p With A and B lotteries, A= [(p,x),(1-p ,y)] and B= [(q,w),(1-q ,z)]

p To reason with uncertainty it is convenient to assume some further

hypothesis about the system of preferences, hypothesis which
guaranty new properties to the utility function with uncertainty, really
simplifying the utility function.
Uncertainty
p These hypothesis are:

p C1: {[(p,x);(1-p,y)]}~z} and {[(p,x);(1-p,y)]{~z} are closed sets, with

x,y,z belonging to the space of possible lotteries (continuity)

p C2: If x~y, then [(p,x);(1-p,z)] ~ [(p,y);(1-p,z)]

p C3: There is a lottery better than all the others b and a lottery worse
than all the others w

p C4: [(p,b),(1-p,w)] is preferred to [(q,b),(1-q,w)] iff p>q

Expected utility function
p With the previous hypothesis we can proof the following result:

p There is an utility function in the space of all lotteries such that:

U[(p,x),(1-p,y)] = p.U(x)+(1-p).U(y)

q We can even proof that such a function is unique under any linear
transformation (affine transformation) V(.) = a.U(.)+b, with a>0.
Expected utility function
p An utility function with these properties is called a Von Neumann-
Morgenstern (VN-M) Utility Function.

p Under these hypothesis, the utility of a lottery is given by the expected

value of the utilities of each possible outcome: the expected utility.

p We will show a graphic example. Suppose there is a single good

(money) and a lottery in which you receive x1 with probability 50% or
x2 with probability 50%.
 Expected utility function
p U(x)

U(x2)

E(U(x1,x2))

U(x1)

U(x1)/2+U(x2)/2 < U(x1/2+x2/2)

x1 x2 x
Risk aversion
p As we have aVon Neumann-Morgenstern (VN-M) utility function, the
utility of this lottery is given by the expected value of the utilities of
each possible outcome.

p In the represented example, the economic agent is risk-averse, i.e., he

prefers to receive the expected value of the eventual results than the
stochastic outcome of the lottery.

p This risk aversion is a consequence of the concavity of the utility

function.

p If U(x) were convex, the economic agent would be a risk lover,

preferring to play the lottery to receiving its expected value.
p.U(x1)+(1-p).U(x2) > U(p.x1+(1-p).x2)
Risk aversion
p In general, we assume that economic agents are risk averse, meaning
that their VN-M utilities are concave.

p Risk aversion increases with the concavity of the utility functions.

p Hence, a common measure of risk aversion is related with the 2nd

derivative of the utility function, U(.). As we want this measure to be
invariant to linear transformations (what is not true to 2nd derivatives)
we use the ratio

r(x) =-U(x)/U(x)

q This is the Arrow-Pratt ratio to measure absolute risk aversion.

Averso ao risco
p This ratio does not depend on the initial income level.

p However, it is not the same thing to risk 10 having 100 or 100

thousand.

p Hence the idea of proposing a coefficient relative risk aversion

r(x) =-U(x)/(U(x)/x)
Exercises
1.
One of the main components of risk affecting the housing market is the future evolution of the interest
rate. When a family buys a house using mortgage credit, the annual cost of interest is iV , i being the
interest rate and V the initial cost (value) of the house.
Suppose Mr. Fortunato has an annual income of 15.400 euros, and wants to buy a house costing 90.000
euros. Inquiryng the banking market, the best 2 financial offers are: contracting a fixed rate of 9%
annually or a variable rate; in the latter contract, Mr. Fortunato knows the rate may be 6% or 10% , and
only one of these values.
a) Admitting the banks are risk neutral, what is their assessment of the probability that the future
average rate will be 6% ? Justify.
b) Is it reasonable to assume that banks are risk neutral? Explain.
c) If the consumer is risk averse and has the same beliefs as the market concerning the evolution of
mortgage rates, what financing option should he choose, fixed or variable rate? Justify.
d) Assume now that Mr. Fortunato believes he is better informed than the market and estimates that
the probabilities for the future value of the interest rate are: P( i = 6% ) = 0,5 and P( i = 10% ) =
0,5 . If his income VN-M utility function is U (M) = M , what kind of financing should he choose?
e) What should be the fixed interest rate to make Mr. Fortunato indifferent between both kind of
financing contracts?
f) Compute the risk aversion coefficient for this consumer.
Exercises
p 2.

Suppose an investor wealth given by W = 100: He may invest this wealth in Money (M), with
interest rate iM = 0, or bonds with stochastic interest rate iB . This latter rate may be iB1 = 10% ,
with probability pB1 = 0,9 , or iB2 = - 75% , with probability pB2 = 0,1.

a) If the VN-M utility function of the investor is U (W) = W , what is his optimal portfolio?

b) How does the optimal portfolio changes if the investors utility function is U (W) = W 2/3 ?

p 3.

Suppose now that the investor is given a third alternative: to invest in stocks, in which case the rate
may be iS1 = 16% , with probability pS1 = 0,5 , or iS2 = - 15% , with probability pS2 = 0,5.
Find the optimal portfolio.