Chapter 5: Uncertainty and Consumer Behavior Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 76 CHAPTER 5 UNCERTAINTY AND CONSUMER BEHAVIOR TEACHING NOTES This is a useful chapter for business-oriented courses, particularly if you intend to cover the role of risk in capital markets in Chapter 15. It is also good background for Chapter 17 on asymmetric information. On the other hand, you will not able to cover everything in the book, so if there are other topics you wish to cover instead, you may skip this chapter without disrupting the overall flow of the text. You might start by asking students how uncertainty affects the decisions made by consumers and firms. Consumers may not know their incomes for sure, they are uncertain about the quality of some of the goods they buy (so it is difficult to know the utility they will receive from purchasing those goods); business firms are uncertain about the demands for their products, the future costs of inputs, and the exchange rate for foreign currencies; investors don’t know whether their investments will increase or decrease in value; etc. Then ask how people deal with these risks. For example, there are many types of insurance including auto, life and unemployment, companies offer product warranties and refunds, farmers and other firms can hedge against price uncertainty in futures markets, businesses can hedge foreign exchange risks in forward markets, and investors can diversity. If students have not previously been exposed to probability, expected value, and variance, the basics are covered in Section 5.1. However, this is a fast run-through even for those who have had a basic statistics course, so you may find Exercises 1 through 5 useful as they provide practice calculating expected value and variance. Many students think of risk as arising from the possibility of loss or injury; they do not consider that risk can also be due to uncertain gains. It is easy to construct simple examples where there are only gains to make the point that risk still exists. For example, with alternative 1 you get nothing if a coin comes up heads and $1000 if it comes up tails. With alternative 2, you get $300 for sure. Alternative 1 is clearly more risky. You can mention that variance (or standard deviation), which is often used as a measure of riskiness, takes into account both gains and losses. Preferences toward risk depend on the decision maker’s von Neumann-Morgenstern utility function, which is different from the utility functions in Chapters 3 and 4. Utility in this chapter has some cardinal properties and depends on the monetary payoff to the decision maker, whereas utility in earlier chapters was ordinal and depended on the amount of various goods consumed. To emphasize this difference, utility is denoted by a lower case u in this chapter. There are a number of issues that trip up students in Chapter 5. Most importantly, students often confuse expected utility and the utility of the expected value. Give them a couple of examples to make sure they understand the difference. For instance, if x x u = ) ( , the expected utility for alternative 1 in the example above is 81 . 15 1000 5 . 0 0 5 . 0 ) 1000 ( 5 . 0 ) 0 ( 5 . 0 = + = + = u u Eu . On the other hand, the expected value for alternative 1 is 500 ) 1000 ( 5 . 0 ) 0 ( 5 . 0 ) ( = + = x E , and the utility of the expected value is therefore 36 . 22 500 )] ( [ = = x E u , which is quite different from the expected utility. Students also have difficulty understanding Figure 5.4 that illustrates the risk premium. They do not understand why the point on the chord (point F) represents expected utility. You will need to explain this carefully. You should also make sure students understand that even risk averse people take risks. Being risk averse does not mean avoiding all risks. Everyone takes risks when the possible rewards are greater than the costs. For instance, most people have parked illegally when they are in a hurry (or late for an exam). We all drive cars, risking accidents and injury, and many people buy stocks and bonds even though those investments may decrease in value. In fact, there really is no way to live and avoid all risks.