Uncertainty and Consumer Behavior

Chapter 5
Uncertainty and Consumer Behavior
Topics to be Discussed
Describing Risk
Preferences Toward Risk

Reducing Risk
The Demand for Risky Assets
2005 Pearson Education, Inc.
Chapter 5
Introduction
Choice with certainty is reasonably straightforward How do we make choices when certain variables such as income and prices are uncertain (making choices with risk)?
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Describing Risk
To measure risk we must know:
1. All of the possible outcomes

2. The probability or likelihood that each outcome will occur
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Describing Risk
Interpreting Probability
1. Objective Interpretation
Based on the observed frequency of past events Based on perception that an outcome will occur
2. Subjective Interpretation
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Interpreting Probability
Subjective Probability
Different information or different abilities to process the same information can influence the subjective probability Based on judgment or experience
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Describing Risk
With an interpretation of probability, must determine 2 measures to help describe and compare risky choices
1. Expected value 2. Variability
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Describing Risk
Expected Value
The weighted average of the payoffs or values resulting from all possible outcomes
Expected
value measures the central tendency; the payoff or value expected on average
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Expected Value An Example

Investment in offshore drilling exploration: Two outcomes are possible
Success the stock price increases from $30 to $40/share Failure the stock price falls from $30 to $20/share
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Objective Probability
100 explorations, 25 successes and 75 failures Probability (Pr) of success = 1/4 and the probability of failure = 3/4
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10

EV Pr(success )(value of success) Pr(failure )(value of failure)
EV 1 4 ($40/share ) 3 4 ($20/share )
EV $25/share
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Expected Value
In general, for n possible outcomes:
Possible outcomes having payoffs X1, X2, , Xn Probabilities of each outcome is given by Pr1, Pr2, , Prn
E(X) Pr1 X 1 Pr 2 X 2 ... Pr n X n
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Describing Risk
Variability
The extent to which possible outcomes of an uncertain event may differ How much variation exists in the possible choice
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Variability An Example
Suppose you are choosing between two part-time sales jobs that have the same expected income ($1,500) The first job is based entirely on commission The second is a salaried position
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There are two equally likely outcomes in the first job: $2,000 for a good sales job and $1,000 for a modestly successful one The second pays $1,510 most of the time (.99 probability), but you will earn $510 if the company goes out of business (.01 probability)
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Outcome 1 Prob. Job 1: Commission Job 2: Fixed Salary .5 .99 Income 2000 1510 Outcome 2 Prob. .5 .01 Income 1000 510
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Income from Possible Sales Job Job 1 Expected Income
E(X 1 ) .5($2000) .5($1000) $1500

Job 2 Expected Income
E(X 2 ) .99($1510) .01($510) $1500

Variability
While the expected values are the same, the variability is not Greater variability from expected values signals greater risk Variability comes from deviations in payoffs
Difference between expected payoff and actual payoff
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Deviations from Expected Income ($)
Outcome Deviation Outcome Deviation 1 2
Job 1 Job 2
$2000 1510
$500 10
$1000 510
-$500 -900
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Variability
Average deviations are always zero so we must adjust for negative numbers We can measure variability with standard deviation
The square root of the average of the squares of the deviations of the payoffs associated with each outcome from their expected value
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Variability
Standard deviation is a measure of risk
Measures how variable your payoff will be More variability means more risk Individuals generally prefer less variability less risk
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Variability
The standard deviation is written:
Pr1X1 E ( X ) Pr2 X 2 E ( X )
2
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Standard Deviation Example 1

Deviations from Expected Income ($)
Outcome Deviation Outcome Deviation 1 2
Job 1 Job 2
$2000 1510
$500 10
$1000 510
-$500 -900
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Standard deviations of the two jobs are:
Pr1X1 E ( X )2 Pr2 X 2 E ( X )2
1 0.5($250 ,000 ) 0.5($250 ,000 ) 1 250 ,000 500
2 0.99 ($ 100 ) 0.01($980 ,100 ) 2 9,900 99 .50

Job 1 has a larger standard deviation and therefore it is the riskier alternative The standard deviation also can be used when there are many outcomes instead of only two
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Job 1 is a job in which the income ranges from $1000 to $2000 in increments of $100 that are all equally likely Job 2 is a job in which the income ranges from $1300 to $1700 in increments of $100 that, also, are all equally likely
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Outcome Probabilities - Two Jobs

Probability
Job 1 has greater spread: greater standard deviation and greater risk than Job 2.
0.2
Job 2
0.1
Job 1
$1000
$1500
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$2000
Income
27
Decision Making Example 1

What if the outcome probabilities of two jobs have unequal probability of outcomes?
Job 1: greater spread and standard deviation Peaked distribution: extreme payoffs are less likely that those in the middle of the distribution You will choose job 2 again
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Unequal Probability Outcomes

Probability
The distribution of payoffs associated with Job 1 has a greater spread and standard deviation than those with Job 2.
0.2
Job 2
0.1
Job 1
$1000
$1500
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$2000
Income
29

Suppose we add $100 to each payoff in Job 1 which makes the expected payoff = $1600
Job 1: expected income $1,600 and a standard deviation of $500 Job 2: expected income of $1,500 and a standard deviation of $99.50
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Which job should be chosen?
Depends on the individual Some may be willing to take risk with higher expected income Some will prefer less risk even with lower expected income
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Risk and Crime Deterrence

Attitudes toward risk affect willingness to break the law Suppose a city wants to deter people from double parking Monetary fines may be better than jail time
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Risk and Crime Deterrence

Costs of apprehending criminals are not zero, therefore
Fines must be higher than the costs to society Probability of apprehension is actually less than one
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Risk and Crime Deterrence Example

Assumptions:
1. Double-parking saves a person $5 in terms of time spent searching for a parking space 2. The driver is risk neutral 3. Cost of apprehension is zero
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A fine greater than $5.00 would deter the driver from double parking
Benefit of double parking ($5) is less than the cost ($6.00) equals a net benefit that is negative If the value of double parking is greater than $5.00, then the person would still break the law
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The same deterrence effect is obtained by either
A $50 fine with a 0.1 probability of being caught resulting in an expected penalty of $5 or A $500 fine with a 0.01 probability of being caught resulting in an expected penalty of $5
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Enforcement costs are reduced with high fine and low probability Most effective if drivers dont like to take risks
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Can expand evaluation of risky alternative by considering utility that is obtained by risk
A consumer gets utility from income Payoff measured in terms of utility
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Preferences Toward Risk Example

A person is earning $15,000 and receiving 13.5 units of utility from the job She is considering a new, but risky job
0.50 chance of $30,000 0.50 chance of $10,000
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Utility at $30,000 is 18 Utility at $10,000 is 10 Must compare utility from the risky job with current utility of 13.5 To evaluate the new job, we must calculate the expected utility of the risky job
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The expected utility of the risky option is the sum of the utilities associated with all her possible incomes weighted by the probability that each income will occur E(u) = (Prob. of Utility 1) *(Utility 1) + (Prob. of Utility 2)*(Utility 2)
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The expected is:
E(u) = (1/2)u($10,000) + (1/2)u($30,000) = 0.5(10) + 0.5(18) = 14 E(u) of new job is 14, which is greater than the current utility of 13.5 and therefore preferred
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People differ in their preference toward risk People can be risk averse, risk neutral, or risk loving
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Risk Averse
A person who prefers a certain given income to a risky income with the same expected value The person has a diminishing marginal utility of income Most common attitude towards risk
Ex:
Market for insurance
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Risk Averse - Example

A person can have a $20,000 job with 100% probability and receive a utility level of 16 The person could have a job with a 0.5 chance of earning $30,000 and a 0.5 chance of earning $10,000
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Risk Averse Example

Expected Income of Risky Job
E(I) = (0.5)($30,000) + (0.5)($10,000) E(I) = $20,000
Expected Utility of Risky Job

E(u) = (0.5)(10) + (0.5)(18) E(u) = 14
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Risk Averse Example

Expected income from both jobs is the same risk averse may choose current job Expected utility is greater for certain job
Would keep certain job
Risk averse persons losses (decreased utility) are more important than risky gains
Risk Averse
Can see risk averse choices graphically Risky job has expected income = $20,000 with expected utility = 14
Point F
Certain job has expected income = $20,000 with utility = 16

Point D
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Risk Averse Utility Function

Utility
E
D C F
The consumer is risk averse because she would prefer a certain income of $20,000 to an uncertain expected income = $20,000
18
16 14
A 10
0
10
16 20
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Income ($1,000)
49

A person is said to be risk neutral if they show no preference between a certain income, and an uncertain income with the same expected value Constant marginal utility of income
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Risk Neutral
Expected value for risky option is the same as utility for certain outcome
E(I) = (0.5)($10,000) + (0.5)($30,000) = $20,000 E(u) = (0.5)(6) + (0.5)(18) = 12
This is the same as the certain income of $20,000 with utility of 12

Risk Neutral
Utility 18
E
12
The consumer is risk neutral and is indifferent between certain events and uncertain events with the same expected income.
0
10
20
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30
Income ($1,000)
52

A person is said to be risk loving if they show a preference toward an uncertain income over a certain income with the same expected value
Examples: Gambling, some criminal activities
Increasing marginal utility of income
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Risk Loving
Expected value for risky option point F
E(I) = (0.5)($10,000) + (0.5)($30,000) = $20,000 E(u) = (0.5)(3) + (0.5)(18) = 10.5
Certain income is $20,000 with utility of 8 point C Risky alternative is preferred
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Risk Loving
Utility 18 E
The consumer is risk loving because she would prefer the gamble to a certain income.
10.5
8 A 3 0
F C
10
20
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Income ($1,000)
55

The risk premium is the maximum amount of money that a risk-averse person would pay to avoid taking a risk The risk premium depends on the risky alternatives the person faces
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Risk Premium Example

From the previous example
A person has a .5 probability of earning $30,000 and a .5 probability of earning $10,000 The expected income is $20,000 with expected utility of 14
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Point F shows the risky scenario the utility of 14 can also be obtained with certain income of $16,000 This person would be willing to pay up to $4000 (20 16) to avoid the risk of uncertain income Can show this graphically by drawing a straight line between the two points line CF

Utility Risk Premium
Here, the risk premium is $4,000 because a certain income of $16,000 gives the person the same expected utility as the uncertain income with expected value of $20,000.
G
20 18
14
E
C
A
10
0
10
16
20
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30
40
Income ($1,000)
59
Risk Aversion and Income

Variability in potential payoffs increases the risk premium Example:
A job has a .5 probability of paying $40,000 (utility of 20) and a .5 chance of paying 0 (utility of 0).
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Example (cont.):
The expected income is still $20,000, but the expected utility falls to 10
E(u)
= (0.5)u($0) + (0.5)u($40,000) = 0 + .5(20) = 10
The certain income of $20,000 has utility of 16 If person must take new job, their utility will fall by 6
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Example (cont.):
They can get 10 units of utility by taking a certain job paying $10,000 The risk premium, therefore, is $10,000 (i.e. they would be willing to give up $10,000 of the $20,000 and have the same E(u) as the risky job
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The greater the variability, the more the person would be willing to pay to avoid the risk, and the larger the risk premium
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Risk Aversion and Indifference Curves

Can describe a persons risk aversion using indifference curves that relate expected income to variability of income (standard deviation) Since risk is undesirable, greater risk requires greater expected income to make the person equally well off Indifference curves are therefore upward sloping

Expected Income
U3 U2 U1
Highly Risk Averse: An increase in standard deviation requires a large increase in income to maintain satisfaction.
Standard Deviation of Income


Expected Income Slightly Risk Averse: A large increase in standard deviation requires only a small increase in income to maintain satisfaction.
U3
U2 U1
Standard Deviation of Income

Reducing Risk
Consumers are generally risk averse and therefore want to reduce risk Three ways consumers attempt to reduce risk are:
1. Diversification 2. Insurance 3. Obtaining more information
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Reducing Risk
Diversification
Reducing risk by allocating resources to a variety of activities whose outcomes are not closely related
Example:
Suppose a firm has a choice of selling air conditioners, heaters, or both The probability of it being hot or cold is 0.5 How does a firm decide what to sell?
Income from Sales of Appliances

Hot Weather Air conditioner sales Heater sales
Cold Weather
$12,000
$30,000
12,000
30,000
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Diversification Example
If the firm sells only heaters or air conditioners their income will be either $12,000 or $30,000 Their expected income would be:
1/2($12,000) + 1/2($30,000) = $21,000
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If the firm divides their time evenly between appliances, their air conditioning and heating sales would be half their original values If it were hot, their expected income would be $15,000 from air conditioners and $6,000 from heaters, or $21,000 If it were cold, their expected income would be $6,000 from air conditioners and $15,000 from heaters, or $21,000
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With diversification, expected income is $21,000 with no risk Better off diversifying to minimize risk Firms can reduce risk by diversifying among a variety of activities that are not closely related
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Reducing Risk The Stock Market

If invest all money in one stock, then take on a lot of risk
If that stock loses value, you lose all your investment value
Can spread risk out by investing in many different stocks or investments

Ex: Mutual funds
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Reducing Risk Insurance

Risk averse are willing to pay to avoid risk If the cost of insurance equals the expected loss, risk averse people will buy enough insurance to recover fully from a potential financial loss
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The Decision to Insure
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75
Reducing Risk Insurance

For the risk averse consumer, guarantee of same income regardless of outcome has higher utility than facing the probability of risk Expected utility with insurance is higher than without
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The Law of Large Numbers

Insurance companies know that although single events are random and largely unpredictable, the average outcome of many similar events can be predicted When insurance companies sell many policies, they face relatively little risk
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Reducing Risk Actuarially Fair

Insurance companies can be sure total premiums paid will equal total money paid out Companies set the premiums so money received will be enough to pay expected losses
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Reducing Risk Actuarially Fair

Some events with very little probability of occurrence such as floods and earthquakes are no longer insured privately
Cannot calculate true expected values and expected losses Governments have had to create insurance for these types of events
Ex:
National Flood Insurance Program
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The Value of Information

Risk often exists because we dont know all the information surrounding a decision Because of this, information is valuable and people are willing to pay for it
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The Value of Information

The value of complete information
The difference between the expected value of a choice with complete information and the expected value when information is incomplete
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The Value of Information Example

Per capita milk consumption has fallen over the years The milk producers engaged in market research to develop new sales strategies to encourage the consumption of milk
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82

Findings
Milk demand is seasonal with the greatest demand in the spring Price elasticity of demand is negative and small Income elasticity is positive and large
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Milk advertising increases sales most in the spring Allocating advertising based on this information in New York increased profits by 9% or $14 million The cost of the information was relatively low, while the value was substantial (increased profits)
Demand for Risky Assets

Most individuals are risk averse and yet choose to invest money in assets that carry some risk
Why do they do this? How do they decide how much risk to bear?
Must examine the demand for risky assets
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85

Assets
Something that provides a flow of money or services to its owner
Ex:
homes, savings accounts, rental property, shares of stock
The flow of money or services can be explicit (dividends) or implicit (capital gain)
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Capital Gain
An increase in the value of an asset
Capital loss
A decrease in the value of an asset
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87
Risky and Riskless Assets

Risky Asset
Provides an uncertain flow of money or services to its owner Examples
Apartment
rent, capital gains, corporate bonds, stock prices Dont know with certainty what will happen to the value of a stock
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88
Risky and Riskless Assets

Riskless Asset
Provides a flow of money or services that is known with certainty Examples
Short-term
government bonds, short-term certificates of deposit
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89

People hold assets because of the monetary flows provided To compare assets, one must consider the monetary flow relative to the assets price (value) Return on an asset
The total monetary flow of an asset, including capital gains or losses, as a fraction of its price
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90

Individuals hope to have an asset that has returns larger than the rate of inflation
Want to have greater purchasing power
Real Return of an Asset (inflation adjusted)

The simple (or nominal) return less the rate of inflation
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91

Since returns are not known with certainty, investors often make decisions based on expected returns Expected Return
Return that an asset should earn on average In the end, the actual return could be higher or lower than the expected return
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92
Investments Risk and Return (1926-1999)
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93

The higher the return, the greater the risk Investors will choose lower return investments in order to reduce risk A risk-averse investor must balance risk relative to return
Must study the trade-off between return and risk
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94
Trade-offs: Risk and Returns Example

An investor is choosing between T-Bills and stocks:
1. T-bills riskless 2. Stocks risky
Investor can choose only T-bills, only stocks, or some combination of both
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Rf = risk-free return on T-bill
Expected return equals actual return on a riskless asset
Rm = the expected return on stocks rm = the actual returns on stock Assume Rm > Rf or no risk averse investor would buy the stocks
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How do we determine the allocation of funds between the two choices?
b = fraction of funds placed in stocks (1-b) = fraction of funds placed in T-bills
Expected return on portfolio is weighted average of expected return on the two assets
RP bRm (1 b) R f

Assume, Rm = 12%, Rf = 4%, and b = 1/2
RP bRm (1 b) R f RP (1 / 2)(12%) (1 1 / 2)(4%) RP 8%


How risky is the portfolio?
As stated before, one measure of risk is standard deviation Standard deviation of the risky asset, m Standard deviation of risky portfolio, p Can show that:
p b m

We still need to figure out the allocation between the investment choices A type of budget line can be constructed describing the trade-off between risk and expected return
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R p bRm (1 b) R f Rp R f ( Rm R f )
Expected return on the portfolio, rp increases as the standard deviation, p of that return increases

The slope of the line is called the price of risk
Tells how much extra risk an investor must incur to enjoy a higher expected return
Slope (Rm Rf )/ m
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Choosing Between Risk and Return

If all funds are invested in T-bills (b=0), expected return is Rf If all funds are invested in stocks (b=1), expected return is Rm but with standard deviation of m Funds may be invested between the assets with expected return between Rf and Rm, with standard deviation between m and 0

We can draw indifference curves showing combinations of risk and return that leave an investor equally satisfied Comparing the payoffs and risk between the two investment choices and the preferences of the investor, the optimal portfolio choice can be determined Investor wants to maximize utility within the affordable options

Expected Return,Rp
U2 is the optimal choice since it gives the highest return for a given risk and is still affordable
U3 U2 U1 Rm R* Rf
Budget Line
2005 Pearson Education, Inc. Chapter 5
Standard Deviation of Return, p

105

Different investors have different attitudes toward risk If we consider a very risk averse investor (A)
Portfolio will contain mostly T-bills and less in stock, with return slightly larger than Rf
If we consider a riskier investor (B)

Portfolio will contain mostly stock and less T-bills, with a higher return Rb but with higher standard deviation
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The Choices of Two Different Investors

Expected Return,Rp
UB
UA
Budget line
Given the same budget line, investor A chooses low return/low risk, while investor B chooses high return/high risk.
Rm
RB
RA R
f
A
B
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Standard Deviation of Return, p

107
Investing in the Stock Market

In 1990s many people began investing in the stock market for the first time
Percent of US families who had directly or indirectly invested in the stock market
1989
= 32% 1998 = 49%
Percent with share of wealth in stock market

1989
= 26% 1998 = 54%
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Investing in the Stock Market

Why were stock market investments increasing during the 90s?
Ease of online trading Significant increase in stock prices during late 90s Employers shifting to self-directed retirement plans Publicity for do it yourself investing
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109
Behavioral Economics
Sometimes individuals behavior contradicts basic assumptions of consumer choice
More information about human behavior might lead to better understanding This is the objective of behavioral economics
Improving
understanding of consumer choice by incorporating more realistic and detailed assumptions regarding human behavior
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110
There are a number of examples of consumer choice contradictions
You take at trip and stop at a restaurant that you will most likely never stop at again. You still think it fair to leave a 15% tip rewarding the good service. You choose to buy a lottery ticket even though the expected value is less than the price of the ticket
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Reference Points
Economists assume that consumers place a unique value on the goods/services purchased Psychologists have found that perceived value can depend on circumstances
You
are able to buy a ticket to the sold out Cher concert for the published price of $125. You find out you can sell the ticket for $500 but you choose not to, even though you would never have paid more than $250 for the ticket.
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Reference Points (cont.)
The point from which an individual makes a consumption decision From the example, owning the Cher ticket is the reference point
Individuals
dislike losing things they own They value items more when they own them than when they do not Losses are valued more than gains Utility loss from selling the ticket is greater than original utility gain from purchasing it
Experimental Economics
Students were divided into two groups Group one was given a mug with a market value of $5.00 Group two received nothing Students with mugs were asked how much they would take to sell the mug back
Lowest
price for mugs, on average, was $7.00
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Experimental Economics (cont.)
Group without mugs was asked minimum amount of cash they would except in lieu of the mug
On
average willing to accept $3.50 instead of getting the mug
Group one had reference point of owning the mug Group two had reference point of no mug
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115
Fairness
Individuals often make choices because they think they are fair and appropriate
Charitable
giving, tipping in restaurants
Some consumers will go out of their way to punish a store they think is unfair in their pricing Manager might offer higher than market wages to make for happier working environment or more productive worker
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The Laws of Probability
Individuals dont always evaluate uncertain events according to the laws of probability Individuals also dont always maximize expected utility Law of small numbers
Overstate
probability of an event when faced with little information Ex: overstate likelihood they will win the lottery
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117
Theory up to now has explained much but not all of consumer choice Although not all of consumer decisions can be explained by the theory up to this point, it helps us understand much of it Behavioral economics is a developing field to help explain and elaborate on situations not well explained by the basic consumer model

Uncertainty and Consumer Behavior

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Uncertainty and Consumer Behavior

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Chapter 5

Uncertainty and Consumer Behavior

Preferences Toward Risk

The Demand for Risky Assets

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

1. All of the possible outcomes

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

Expected Value An Example

2005 Pearson Education, Inc.

Expected Value An Example

2005 Pearson Education, Inc.

Expected Value An Example

E(X) Pr1 X 1 Pr 2 X 2 ... Pr n X n

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

E(X 1 ) .5($2000) .5($1000) $1500

E(X 2 ) .99($1510) .01($510) $1500

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

Standard Deviation Example 1

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Standard Deviation Example 1

Standard Deviation Example 1

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Standard Deviation Example 2

2005 Pearson Education, Inc.

Outcome Probabilities - Two Jobs

Decision Making Example 1

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Unequal Probability Outcomes

Decision Making Example 2

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Decision Making Example 2

2005 Pearson Education, Inc.

Risk and Crime Deterrence

2005 Pearson Education, Inc.

Risk and Crime Deterrence

2005 Pearson Education, Inc.

Risk and Crime Deterrence Example

2005 Pearson Education, Inc.

Risk and Crime Deterrence Example

2005 Pearson Education, Inc.

Risk and Crime Deterrence Example

2005 Pearson Education, Inc.

Risk and Crime Deterrence Example

2005 Pearson Education, Inc.

Preferences Toward Risk

2005 Pearson Education, Inc.

Preferences Toward Risk Example

2005 Pearson Education, Inc.

Preferences Toward Risk Example