Tag: Decision Making under Uncertainty and Attitude towards Risk

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

1.

Decision-making under risk differs from decision-making under uncertainty because:
A) Under risk, probabilities of outcomes are known.
B) Under uncertainty, outcomes are known but not probabilities.
C) Both A and B are correct.
D) Neither A nor B.
Answer: C

2.

Which of the following statements describes the Expected Utility Theory?
A) Individuals maximize expected income.
B) Individuals maximize expected satisfaction.
C) Individuals maximize expected utility.
D) Individuals minimize expected loss.
Answer: C

3.

The concept of Expected Utility was introduced by:
A) Adam Smith
B) von Neumann and Morgenstern
C) J.R. Hicks
D) Milton Friedman
Answer: B

4.

Expected Utility is calculated as:

$E U = \sum p_{i} \times U (x_{i})$

This implies that:
A) Utility depends only on income.
B) Expected utility is the weighted average of utilities.
C) Probabilities are irrelevant.
D) Only risk-free options matter.
Answer: B

5.

A person is said to be risk-averse if:
A) They prefer risky outcomes to certain ones.
B) They are indifferent between risky and certain outcomes.
C) They prefer certainty to risk with the same expected value.
D) They dislike certainty.
Answer: C

6.

For a risk-averse individual, the utility function is:
A) Linear
B) Concave to the origin
C) Convex to the origin
D) Vertical
Answer: B

7.

A risk lover has a utility function that is:
A) Concave
B) Linear
C) Convex
D) Steeply declining
Answer: C

8.

A risk-neutral person has:
A) Diminishing marginal utility of income
B) Constant marginal utility of income
C) Increasing marginal utility of income
D) No marginal utility
Answer: B

9.

The Certainty Equivalent (CE) refers to:
A) Expected value of income
B) Guaranteed income providing same utility as expected utility of risky prospect
C) Minimum income level
D) The probability of a risky event
Answer: B

10.

If a person is risk-averse, then the certainty equivalent will be:
A) Greater than expected income
B) Less than expected income
C) Equal to expected income
D) Independent of expected utility
Answer: B

11.

The Risk Premium is defined as:
A) The amount paid to avoid risk
B) The extra return for taking risk
C) The probability of success in risky projects
D) The difference between utility and income
Answer: A

12.

The mathematical expression for the Risk Premium is:

$R P = E (W) - C E$

For a risk-averse individual, this will be:
A) Positive
B) Negative
C) Zero
D) Undefined
Answer: A

13.

The Arrow-Pratt Measure of Risk Aversion is given by:

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

It measures:
A) Risk tolerance
B) Curvature of the utility function
C) Expected value of risk
D) Marginal probability
Answer: B

14.

When $U^{''} (W) < 0$ , the individual is:
A) Risk-averse
B) Risk-neutral
C) Risk-loving
D) Indifferent
Answer: A

15.

Under the Maximin Criterion, the decision-maker:
A) Chooses the alternative with the maximum possible payoff
B) Chooses the alternative with the maximum of the minimum payoffs
C) Chooses based on highest average payoff
D) Ignores the worst outcomes
Answer: B

16.

The Maximax Criterion is typically adopted by:
A) Pessimists
B) Optimists
C) Realists
D) Neutral decision-makers
Answer: B

17.

The Hurwicz Criterion uses:
A) Probabilities of all outcomes
B) Coefficient of optimism between 0 and 1
C) Only maximum payoff
D) Only minimum payoff
Answer: B

18.

The Laplace Criterion assumes:
A) Equal probabilities for all outcomes
B) Unequal probabilities
C) Extreme pessimism
D) Extreme optimism
Answer: A

19.

The Minimax Regret Criterion focuses on:
A) Maximizing profit
B) Minimizing maximum possible loss
C) Minimizing maximum regret
D) Maximizing minimum gain
Answer: C

20.

Which decision rule is associated with a pessimistic outlook?
A) Maximax
B) Maximin
C) Laplace
D) Hurwicz
Answer: B

21.

According to Expected Utility Theory, rational individuals will choose:
A) The option with maximum expected income
B) The option with maximum expected utility
C) The option with least variance
D) The option with least cost
Answer: B

22.

Which of the following correctly represents risk aversion?
A) $U (E (W)) = E [U (W)]$
B) $U (E (W)) > E [U (W)]$
C) $U (E (W)) < E [U (W)]$
D) $U (E (W)) = 0$
Answer: B

23.

The concept of risk premium arises because of:
A) Diminishing marginal utility of income
B) Increasing marginal utility of income
C) Constant marginal utility
D) No marginal utility
Answer: A

24.

The Expected Monetary Value (EMV) criterion differs from Expected Utility Theory because:
A) It ignores risk preferences
B) It measures subjective utility
C) It uses non-probabilistic outcomes
D) It considers regret
Answer: A

25.

If the utility function is linear, the person is:
A) Risk-averse
B) Risk-neutral
C) Risk-loving
D) Risk-ignorant
Answer: B

26.

In the Prospect Theory by Kahneman and Tversky, individuals:
A) Evaluate outcomes based on absolute wealth
B) Evaluate outcomes relative to a reference point
C) Always act rationally
D) Ignore losses
Answer: B

27.

According to Prospect Theory, individuals exhibit:
A) Risk-seeking behaviour in gains and risk aversion in losses
B) Risk aversion in gains and risk-seeking in losses
C) Neutral behaviour
D) Indifference between gain and loss
Answer: B

28.

In real-world decision-making, individuals often satisfice rather than maximize. This concept was proposed by:
A) John von Neumann
B) Herbert Simon
C) Milton Friedman
D) Kenneth Arrow
Answer: B

29.

A risk-neutral firm evaluates projects based on:
A) Expected profit only
B) Expected utility
C) Risk premium
D) Certainty equivalent
Answer: A

30.

Which of the following statements is true about decision-making under uncertainty?
A) Probabilities of outcomes are precisely known.
B) Expected utility can always be calculated.
C) Decision depends on subjective attitude towards risk.
D) Risk premium is always zero.
Answer: C

October 31, 2025

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.

2. Types of Decision-Making Situations

Situation	Knowledge of Outcomes	Knowledge of Probabilities	Example
Certainty	Complete	Complete	Buying a fixed-return bond
Risk	Known outcomes	Probabilities known	Gambling, insurance
Uncertainty	Known outcomes	Probabilities unknown	Launching a new product in a new market

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

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:

$E U = \sum p_{i} \times U (x_{i})$

Where:

$E U$ = 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.

Example

A person faces two choices:

Option	Possible Income (₹)	Probability	Utility (U = √x)
A	100	1.0	10
B	50 (p = 0.5), 150 (p = 0.5)	–	$0.5 (√ 50) + 0.5 (√ 150) = 0.5 (7.07) + 0.5 (12.25) = 9.66$

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

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.

Attitude	Utility Function	Curve Shape	Example
Risk Averse	$U (W) = \sqrt{W}$	Concave	Insurance buyer
Risk Neutral	$U (W) = W$	Linear	Investor in T-bills
Risk Lover	$U (W) = W^{2}$	Convex	Gambler

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.

$Risk Premium = E (W) - C E$

Where:

$E (W)$ = Expected income
$C E$ = Certainty Equivalent (guaranteed income yielding same utility as risky income)

For a risk-averse person:

$Risk Premium > 0$

For a risk lover:

$Risk Premium < 0$

(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:

$U (C E) = E U$

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

(c) Arrow-Pratt Measure of Risk Aversion

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

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

Higher $r (W)$ indicates greater risk aversion.
It measures the curvature (concavity) of the utility function.

6. Decision-Making under Uncertainty

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

Criterion	Description	Typical Decision-Maker
Maximin (Wald’s Criterion)	Choose the alternative with the best of the worst possible outcomes.	Pessimist (Risk-averse)
Maximax Criterion	Choose the alternative with the best of the best outcomes.	Optimist (Risk-loving)
Hurwicz Criterion	Weighted average of max and min payoffs; includes a coefficient of optimism (α) between 0 and 1.	Realist
Laplace Criterion	Treat all outcomes as equally probable; choose the option with the highest average payoff.	Neutral decision-maker
Minimax Regret Criterion (Savage)	Choose the decision that minimizes the maximum regret.	Cautious decision-maker

7. Application of Risk and Uncertainty in Economics

Insurance Markets:
Risk-averse individuals pay a premium to avoid uncertainty.
Explains why insurance companies thrive.
Investment Decisions:
Investors diversify portfolios to reduce risk without reducing returns (Markowitz portfolio theory).
Agricultural Decisions:
Farmers choose crop patterns balancing expected yield and weather risk.
Firm Behaviour:
Firms hedge against price fluctuations using forward contracts and options.
Public Policy:
Governments design social safety nets considering citizens’ risk aversion.

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.

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.

10. Summary

Concept	Explanation
Risk vs Uncertainty	Risk has measurable probabilities; uncertainty does not.
Expected Utility	Foundation of rational decision-making under risk.
Risk Attitudes	Individuals can be risk-averse, risk-neutral, or risk-loving.
Risk Premium	Price of avoiding risk for risk-averse individuals.
Arrow-Pratt Measure	Quantitative indicator of risk aversion.
Decision Criteria under Uncertainty	Maximin, Maximax, Laplace, Hurwicz, and Minimax Regret.
Prospect Theory	Real-world deviations from expected utility theory.

October 31, 2025