CHAPTER 5,Uncertainty and Consumer Behavior,CHAPTER 5 OUTLINE,5.1 Describing Risk 5.2 Preferences Toward Risk 5.3 Reducing Risk 5.4 The Demand for Risky Assets 5.5 Behavioral Economics,Uncertainty and Consumer Behavior,In order to compare the riskiness of alternative choices, we need to quantify risk. We will examine peoples preferences toward risk. We will see how people can sometimes reduce or eliminate risk. In some situations, people must choose the amount of risk they wish to bear. In the final section of this chapter, we offer an overview of the flourishing field of behavioral economics.,Sometimes we must choose how much risk to bear.,DESCRIBING RISK,Probability,probability Likelihood that a given outcome will occur.,Subjective probability is the perception that an outcome will occur.,expected value Probability-weighted average of the payoffs associated with all possible outcomes.,Expected Value,payoff Value associated with a possible outcome.,The expected value measures the central tendencythe payoff or value that we would expect on average.,Expected value = Pr(success)($40/share) + Pr(failure)($20/share) = (1/4)($40/share) + (3/4)($20/share) = $25/share,E(X) = Pr1X1 + Pr2X2,E(X) = Pr1X1 + Pr2X2 + . . . + PrnXn,DESCRIBING RISK,Variability,variability Extent to which possible outcomes of an uncertain event differ.,deviation Difference between expected payoff and actual payoff.,TABLE 5.1 Income from Sales Jobs,DESCRIBING RISK,Variability,Outcome Probabilities for Two Jobs,The distribution of payoffs associated with Job 1 has a greater spread and a greater standard deviation than the distribution of payoffs associated with Job 2. Both distributions are flat because all outcomes are equally likely.,Figure 5.1,DESCRIBING RISK,Variability,Unequal Probability Outcomes,The distribution of payoffs associated with Job 1 has a greater spread and a greater standard deviation than the distribution of payoffs associated with Job 2. Both distributions are peaked because the extreme payoffs are less likely than those near the middle of the distribution.,Figure 5.2,Decision Making,Fines may be better than incarceration in deterring certain types of crimes, such as speeding, double-parking, tax evasion, and air polluting. Other things being equal, the greater the fine, the more a potential criminal will be discouraged from committing the crime. In practice, however, it is very costly to catch lawbreakers. Therefore, we save on administrative costs by imposing relatively high fines. A policy that combines a high fine and a low probability of apprehension is likely to reduce enforcement costs.,DESCRIBING RISK,PREFERENCES TOWARD RISK,Risk Averse, Risk Loving, and Risk Neutral,In (a), a consumers marginal utility diminishes as income increases. The consumer is risk averse because she would prefer a certain income of $20,000 (with a utility of 16) to a gamble with a .5 probability of $10,000 and a .5 probability of $30,000 (and expected utility of 14).,Figure 5.3,PREFERENCES TOWARD RISK,Risk Averse, Risk Loving, and Risk Neutral,In (b), the consumer is risk loving: She would prefer the same gamble (with expected utility of 10.5) to the certain income (with a utility of 8). Finally, the consumer in (c) is risk neutral, and indifferent between certain and uncertain events with the same expected income.,Figure 5.3, expected utility Sum of the utilities associated with all possible outcomes, weighted by the probability that each outcome will occur.,PREFERENCES TOWARD RISK,risk averse Condition of preferring a certain income to a risky income with the same expected value.,risk neutral Condition of being indifferent between a certain income and an uncertain income with the same expected value.,risk loving Condition of preferring a risky income to a certain income with the same expected value.,Different Preferences Toward Risk,PREFERENCES TOWARD RISK,Different Preferences Toward Risk,Risk Premium,risk premium Maximum amount of money that a risk-averse person will pay to avoid taking a risk.,Risk Premium,Figure 5.4,The risk premium, CF, measures the amount of income that an individual would give up to leave her indifferent between a risky choice and a certain one. Here, the risk premium is $4000 because a certain income of $16,000 (at point C) gives her the same expected utility (14) as the uncertain income (a .5 probability of being at point A and a .5 probability of being at point E) that has an expected value of $20,000.,PREFERENCES TOWARD RISK,Different Preferences Toward Risk,Risk Aversion and Income,The extent of an individuals risk aversion depends on the nature of the risk and on the persons income. Other things being equal, risk-averse people prefer a smaller variability of outcomes. The greater the variability of income, the more the person would be willing to pay to avoid the risky situation.,PREFERENCES TOWARD RISK,Different Preferences Toward Risk,Risk Aversion and Indifference Curves,Figure 5.5,Part (a) applies to