UGC NET Economics Unit 1-Decision Making under Uncertainty and Attitude towards Risk

1. Introduction

In the real world, economic agents—consumers, firms, and investors—often make choices without knowing future outcomes.
Decision-making under uncertainty deals with how individuals behave when probabilities of outcomes are unknown or imperfectly known.

While decision-making under risk assumes that probabilities can be assigned to possible outcomes, uncertainty implies that such probabilities cannot be objectively known.

Understanding this distinction helps explain how economic agents form expectations, manage risks, and make rational choices under limited information.

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2. Types of Decision-Making Situations

In uncertainty, the decision-maker cannot assign a specific probability to outcomes. Instead, choices depend on attitudes toward risk, beliefs, and subjective expectations.

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3. Decision-Making under Risk: The Expected Utility Theory

The Expected Utility Theory (EUT), developed by John von Neumann and Oskar Morgenstern, explains how rational individuals make risky choices.

The theory assumes that individuals choose among risky alternatives to maximize expected utility, not expected monetary value.

Formula:

$$EU=\sum p_i\times U(x_i)$$

Where:

• $EU$ = Expected Utility

• $p_i$ = Probability of outcome $i$

• $U(x_i)$ = Utility from outcome $x_i$

Thus, individuals prefer the choice with the highest expected utility.

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Example

A person faces two choices:

Even though both options have the same expected value (₹100), Option A gives higher utility (10) — showing risk aversion.

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4. Attitude towards Risk

Individuals differ in their willingness to take risks.
These attitudes can be represented through the shape of their utility function.

A. Risk Averse

• Prefers certainty over risk with the same expected value.

• Concave utility function (U’’ < 0).

• Diminishing marginal utility of income.

• Example: Buying insurance against uncertain loss.

B. Risk Neutral

• Indifferent between risky and certain options with same expected value.

• Linear utility function.

• Concerned only with expected income, not variability.

C. Risk Lover (Risk Seeker)

• Prefers risky prospects with the same expected value.

• Convex utility function (U’’ > 0).

• Increasing marginal utility of income.

• Example: Gambling behaviour.

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5. Measurement of Risk Attitudes

Economists use several measures to quantify risk preference:

(a) Risk Premium

The risk premium is the maximum amount of money a risk-averse person is willing to pay to avoid risk.

$$\text{Risk Premium}=E(W)-CE$$

Where:

• $E(W)$ = Expected income

• $CE$ = Certainty Equivalent (guaranteed income yielding same utility as risky income)

For a risk-averse person:

$$\text{Risk Premium}>0$$

For a risk lover:

$$\text{Risk Premium}<0$$

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(b) Certainty Equivalent (CE)

The certainty equivalent is the amount of sure income that gives the same utility as the expected utility of a risky prospect.

If:

$$U(CE)=EU$$

then the person is indifferent between CE and the risky prospect.

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(c) Arrow-Pratt Measure of Risk Aversion

Proposed by Kenneth Arrow and John Pratt, this is a quantitative measure of risk aversion:

$$r(W)=-\frac{U^{\mathrm{\prime }\mathrm{\prime }}(W)}{U^{\mathrm{\prime }}(W)}$$

• Higher $r(W)$ indicates greater risk aversion.

• It measures the curvature (concavity) of the utility function.

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6. Decision-Making under Uncertainty

When probabilities of outcomes are not known, several decision criteria are used to guide rational choice:

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7. Application of Risk and Uncertainty in Economics

1. Insurance Markets:
   Risk-averse individuals pay a premium to avoid uncertainty.
   Explains why insurance companies thrive.

2. Investment Decisions:
   Investors diversify portfolios to reduce risk without reducing returns (Markowitz portfolio theory).

3. Agricultural Decisions:
   Farmers choose crop patterns balancing expected yield and weather risk.

4. Firm Behaviour:
   Firms hedge against price fluctuations using forward contracts and options.

5. Public Policy:
   Governments design social safety nets considering citizens’ risk aversion.

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8. Behavioural Insights: Beyond Expected Utility

Empirical studies show that real-world decisions often deviate from expected utility predictions.
Key developments include:

• Prospect Theory (Kahneman and Tversky):

  • People evaluate gains and losses relative to a reference point.

  • Losses are felt more intensely than equivalent gains (loss aversion).

  • Explains anomalies like insurance purchase and gambling behaviour.

• Bounded Rationality (Herbert Simon):

  • Individuals “satisfice” rather than maximize, due to limited information and computation ability.

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9. Graphical Representation

1️⃣ Utility under Risk:

• Concave utility curve for risk-averse behaviour.

• Expected Utility < Utility of Certainty Equivalent.

2️⃣ Certainty Equivalent and Risk Premium:

• The vertical gap between the expected utility point and certainty equivalent utility represents the risk premium.

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10. Summary