Advanced Environmental Economics and Policy
ENP 32306
Script – Economics part
Anneli Janzer
, Theme 1 – Risk, expected utility and consumer choice
1. Introduction
• Economics=behaviour and decision making in situations of scarcity, risk and uncertainty. 2
perspectives:
• Positive analysis
• Normative analysis = how policies and decisions should look like
• Rational Choice model: Rationality=instrument
• objective of decision making is not questioned; you can be rational, although your choice might
seem weird in the eyes of others
• never confuse rationality with egoism! If you are rational, does not commit you to assume that
someone is only self-interested; if you are an altruist, you can still make rational decisions
2. Expected Utility Theory
• Assumes that people have preferences over risky choices
• Preferences must fulfil certain requirements in order to ensure that choices between risky
events are rational →the “von Neumann Morgenstern” Axoims:
o Completeness ensures that an individual can always decide between two alternatives
o Transitivity ensures that individuals act consistently (if x > y and y > z we must have x > z)
o Independence ensures that two lotteries, each mixed with a third one, are ordered in the same
way as when the two are presented independently of the third one.
o Continuity (if x > y and y > z we must have combination of x and z~y)
• If all axioms are satisfied:
• Preferences can be presented in a
Utility function
• It can be assumed that individual will
always choose most preferred
alternative available
• Set of actions (e.g. buy don’t buy)
and states of the world (possibilities)
• Well ordered preferences defined
over all possible outcomes
(probability distribution)
• People should choose the action
which maximizes their expected
returns
• You can use monetary values to make a Example
situation mathematically easier, but you don’t P= 80% probability that it is a good bike and 20% probability that it
have to is a bad bike
• Example: St. Petersburg Paradox →probability distribution
(coin toss game: head or tales); discrepancy between what people are willing to pay to enter
the gamble and the infinite expected returns
• Expected payoff= states of the world, can be indefinite=a lot of money (people bet on that game)
e.g. if you paid 20 Rubel, you have to have good chances to make profit!
• →although expected value is indefinite, people are not willing to bet a lot on a game like this (risk)
• People prefer actions which maximize their expected utility
• Expected utility of an action (buy/don’t buy) can be expressed as the probability weighted sum
of utilities of all states (good quality/bad quality)
1
, 3. Risk preferences
• A typical utility curve is assumed to be upward sloping and concave
• Example: Suppose that a consumer has $ 10 of wealth and is contemplating a gamble that
gives him/her the change of winning another 5$ with p= 0.5, or of loosing 5$ with p=0.5.
• The consumer prefers the certain expected value of the gamble over facing the uncertain
gamble (the utility of the expected value is higher than the expected utility of the gamble)
→the consumer is risk-averse
Suppose different shapes of the Utility function:
Expected utility= pA*U(A)+pB*U(B)
→decision might change if subjective probabilities
change
• Absolute vs relatve risk aversion
• risk aversion tells you how an individual and at
the end a society works
• younger people are less risk-avers than older
people! in demographically changed society (more
older people) the society becomes therefore
more risk averse
• also gender differences
• the more risk-averese the more criminal
2
ENP 32306
Script – Economics part
Anneli Janzer
, Theme 1 – Risk, expected utility and consumer choice
1. Introduction
• Economics=behaviour and decision making in situations of scarcity, risk and uncertainty. 2
perspectives:
• Positive analysis
• Normative analysis = how policies and decisions should look like
• Rational Choice model: Rationality=instrument
• objective of decision making is not questioned; you can be rational, although your choice might
seem weird in the eyes of others
• never confuse rationality with egoism! If you are rational, does not commit you to assume that
someone is only self-interested; if you are an altruist, you can still make rational decisions
2. Expected Utility Theory
• Assumes that people have preferences over risky choices
• Preferences must fulfil certain requirements in order to ensure that choices between risky
events are rational →the “von Neumann Morgenstern” Axoims:
o Completeness ensures that an individual can always decide between two alternatives
o Transitivity ensures that individuals act consistently (if x > y and y > z we must have x > z)
o Independence ensures that two lotteries, each mixed with a third one, are ordered in the same
way as when the two are presented independently of the third one.
o Continuity (if x > y and y > z we must have combination of x and z~y)
• If all axioms are satisfied:
• Preferences can be presented in a
Utility function
• It can be assumed that individual will
always choose most preferred
alternative available
• Set of actions (e.g. buy don’t buy)
and states of the world (possibilities)
• Well ordered preferences defined
over all possible outcomes
(probability distribution)
• People should choose the action
which maximizes their expected
returns
• You can use monetary values to make a Example
situation mathematically easier, but you don’t P= 80% probability that it is a good bike and 20% probability that it
have to is a bad bike
• Example: St. Petersburg Paradox →probability distribution
(coin toss game: head or tales); discrepancy between what people are willing to pay to enter
the gamble and the infinite expected returns
• Expected payoff= states of the world, can be indefinite=a lot of money (people bet on that game)
e.g. if you paid 20 Rubel, you have to have good chances to make profit!
• →although expected value is indefinite, people are not willing to bet a lot on a game like this (risk)
• People prefer actions which maximize their expected utility
• Expected utility of an action (buy/don’t buy) can be expressed as the probability weighted sum
of utilities of all states (good quality/bad quality)
1
, 3. Risk preferences
• A typical utility curve is assumed to be upward sloping and concave
• Example: Suppose that a consumer has $ 10 of wealth and is contemplating a gamble that
gives him/her the change of winning another 5$ with p= 0.5, or of loosing 5$ with p=0.5.
• The consumer prefers the certain expected value of the gamble over facing the uncertain
gamble (the utility of the expected value is higher than the expected utility of the gamble)
→the consumer is risk-averse
Suppose different shapes of the Utility function:
Expected utility= pA*U(A)+pB*U(B)
→decision might change if subjective probabilities
change
• Absolute vs relatve risk aversion
• risk aversion tells you how an individual and at
the end a society works
• younger people are less risk-avers than older
people! in demographically changed society (more
older people) the society becomes therefore
more risk averse
• also gender differences
• the more risk-averese the more criminal
2
