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Introduction
The theory
Modelling uncertainty
Applications
Critique
A decision-making framework
given a set of potential states, one and only one of which will occur.
Everything that can affect the outcome and about which there is uncertainty is
part of the state. When the act (ai) is chosen and the state (sj) become
known, the outcome (Oi,j) shall follow, mechanically and with certainty:
State
Act s1 ... sj ... sn
a1 O1,1 O1,j O1,n
...
ai Oi,1 Oi,j Oi,n
...
am Om,1 Om,j Om,n
Note: a finite number of possible acts and a finite number of potential states
(as opposed to a continuum of acts and/or states).
Everything the decision maker cares about, shall be a part of the outcome.
That is, if certain acts or states in themselves are valued positively or
negatively, the relevant aspects of the act or state shall be incorporated into
the outcome; that is, it is assumed that the decision maker has preferences
over outcomes only.
State
Act Bicycle not lost Bicycle lost
No insurance 0 −L
Insurance −γ K K −L −γK
Degrees of uncertainty
The above set up presupposes that the decision maker knows the set of
states.
1) The decision maker knows the set of potential states and is able to assign
a precise probability to each potential state.
2) The decision maker knows the set of potential states, but nothing more.
3) The decision maker does not know the set of potential states.
When only the set of states is known, it does not make sense to put more
weight on the outcomes of one state than those of another.
It is, however, possible to put greater weight on outcomes that are particularly
good or bad. The following decision rule is often recommended:
For each possible act, that is, for each line in the table above, find the
worst outcome.
Judge the act as if this outcome will occur and choose the act that, on this
basis, is the best one.
This is often called the maximin-rule. In order to apply the rule, the decision
maker must be able to rank outcomes; that is, ordinal preferences over
outcomes must exist.
Note:
Case 1) above amounts to postulating the existence of numbers p1, p2, ..., pj,
..., pn, where pj ≥ 0 for all j and p1 + p2 + ... + pj + ... + pn = 1. Here pj is the
probability that state sj will occur:
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the act ai will lead to the outcome Oi,1 with probability p1, Oi,2 with
probability p2, ..., Oi,j with probability pj, ... and Oi,n with probability pn
The decision maker receives the amount xj with probability pj for j = 1, 2, ... n.
It is assumed that pj > 0 for all j (i.e. we ignore ‘probability zero events’) and
p1 + p2 + ... + pj + ... + pn = 1.
Example cont. (bicycle insurance): Assume that the probability that the bicycle
is stolen and lost is p. The the two prospects associated with insurance (I) and
no insurance (N) are
I = { p, K − L − γ K ;1 − p, −γ K }
N = { p, −L;1 − p,0}
Expected utility
(note that, although probabilities may differ, outcomes are the same in both
prospects). Let λ be a number satisfying 0 ≤ λ ≤ 1 and consider the prospect
C = {λ, A;1 − λ, B} .
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First, the lot shall be drawn between A and B, with probabilities λ og 1-λ,
respectively. Then one conducts the lottery specified by either A or B. All in
all, the amount xj is chosen with probability λpj + (1-λ)qj, for all j = 1, 2, ... n.
The assumption states that it shall make no difference if one conducts a direct
lottery with these probabilities, rather than going through the two-stage lottery
involving A and B. That is, the agent is indifferent between the two-stage
lottery described above and the direct lottery
D = {λ p1 + [1 − λ ] q1, x1,..., λ pn + [1 − λ ] qn , xn } .
Example cont. (bicycle insurance): Assume that the probability that the bicycle
is stolen is λ . If the bicycle is stolen, the police investigates and returns the
bicycle with probability 1 − π . It is as if the decision maker is facing a series of
lotteries, where the first involves whether or not the bicycle is stolen and the
second whether or not the bicycle is returned.
Consider first the case in which the decision maker has taken out insurance.
Let S denote the prospect facing the agent after the bicycle has been stolen,
with the two possible outcomes “bicycle is lost” (probability π ) and “bicycle is
returned” (probability 1 − π ), respectively:
S = {π , K − L − γ K ;1 − π , −γ K }
Correspondingly, the prospect facing the agent in the event the bicycle is not
stolen is
NS = {0, K − L − γ K ;1, −γ K }
Instead of considering the above two-stage set up, the agent may just as well
consider the reduced-form prospect
I = { p, K − L − γ K ;1 − p, −γ K }
Similarly, in the case that no insurance is taken out, instead of considering the
combined prospects of whether or not the bicycle is stolen and whether or not
the bicycle is returned, the decision maker may just as well consider the
prospect of whether or not the bicycle is lost:
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N = { p, −L;1 − p,0} .
to
I = { ρ , I;1 − ρ , ∆}
i = { ρ , N;1 − ρ , ∆}
N
When these assumptions (together with some others that are not
controversial) are satisfied, the so-called expected utility theorem holds. It
states that there exists a function u, known as the utility function, defined over
amounts of money, with the property that the decision maker ranks prospects
on the basis of their expected utility,
It is not assumed that the function u exists as a mental reality for the decision
maker. It is only claimed that, given the conditions imposed on the
preferences, the decision maker will act as if expected utility is maximized.
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n
E (v ( x ) ) = ∑ pi v ( xi )
i =1
n
= ∑ pi ⎡⎣a + bu ( xi ) ⎤⎦
i =1
n n
= a∑ pi + b∑ pi u ( xi )
i =1 i =1
= a + bE ( u ( x ) )
risk neutral if E ( u ( x ) ) = u (E ( x ) )
The attitude towards risk may be associated with the shape of the utility
function: the decision maker is
1) E ( g ( X ) ) ≤ g (E ( X ) )
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• Figure 1: Tangent to a concave curve
It follows that
E ( g ( X )) ≤ E ( y ( X ))
= E ( g ( µ ) + g ′ ( µ ) [ X − µ ])
= g ( µ ) + g ′ ( µ ) ⎡⎣E ( X ) − µ ⎤⎦
= g (E ( X ) )
Taylor-approximation to E ( u ) at E ( x ) :
((
E ( u ( x ) ) = E u E ( x ) + ⎡⎣ x − E ( x ) ⎤⎦ ))
⎛ 2⎞
≈ E ⎜ u (E ( x ) ) + u ′ (E ( x ) ) ⎡⎣ x − E ( x ) ⎤⎦ + u ′′ (E ( x ) ) ⎡⎣ x − E ( x ) ⎤⎦ ⎟
1
⎝ 2 ⎠
2
1
(
= u (E ( x ) ) + u ′ (E ( x ) ) ⎡⎣E ( x ) − E ( x ) ⎤⎦ + u ′′ (E ( x ) ) E ⎡⎣ x − E ( x ) ⎤⎦
2
)
= u (E ( x ) ) + u ′′ (E ( x ) ) Var ( x )
1
2
u (E ( x ) ) − E ( u ( x ) ) ≈ − u ′′ (E ( x ) ) Var ( x )
1
2
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In other words: the deviation between expected utility and the utility of the
expected outcome depends on
To adjust for the absolute level of marginal utility (cf the point above about
independence of linear transformations), risk aversion is often measure by the
(Arrow-Pratt) coefficient of absolute risk aversion:
u ′′ (E ( x ) )
rA = .
u ′ (E ( x ) )
Decreasing absolute risk aversion implies that a more wealthy decision maker
requires a lower risk premium, i.e. a smaller difference between expected
return and its certainty equivalent.
u ′′ (E ( x ) ) ⋅ E ( x )
rR = .
u ′ (E ( x ) )
Note that the coefficient of relative risk aversion may be interpreted as the
elasticity of the marginal utility function with respect to wealth.
max y E (U ( qy − c ( y ) − f ) )
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expected price must be larger than average costs, so the firm requires
positive expected profit in order to choose a positive output level;
Diversification
There are two assets A and B that result in different payoffs in two, equally
likely states. The following table summarises outcomes.
State 1 2
Payoff asset A 5 15
Payoff asset B 15 5
Note that each asset has expected payoff equal to 10 ( = 0.5 × 5 + 0.5 × 15 )
and variance equal to 25 ( = 0.5 [5 − 10] + 0.5 [15 − 10] ).
2 2
More generally:
spreading wealth on different assets may reduce risk (unless payoffs are
perfectly correlated) without reducing (expected) payoff;
furthermore, a risk averse agent will be willing to trade off expected gains
in order to obtain lower risk.
Insurance
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Consider the following example:
[1 − p ] u ( R − γ K ) + pu ( R − γ K − L + K )
subject to 0 ≤ γ K ≤ R .
1
Substituting K = [ x2 − R + L] in x1 = R − γ K we have
1− γ
γ 1 γ
x1 + x2 = R− L.
1− γ 1− γ 1− γ
max U ( x1, x2 )
s.t . ρ1x1 + ρ2 x2 = Y
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∂U
∂x1 ρ1
=
∂U ρ 2
∂x1
may be written
[1 − p] u′ ( x1 ) = 1 − γ
pu ′ ( x2 ) γ
Figure: wealth in each state on axes (note: at the 45° line the slope of the
1− p 1− γ
indifference curve equals − ; the slope of the ‘budget line’ is − ).
p γ
Π = γ K − pK
Figure: wealth in each state on axes (note: tangent at the 45° line).
If γ > p (i.e. ‘unfair insurance’), the decision maker will no be fully insured, i.e.
x1 > x2
Risk sharing
Appealing to risk aversion may provide insights into the operation of markets.
π = pR x + py − c ( q )
We have
y =q−x.
Special cases:
x = 0 : generator
q = 0 : supplier (retailer)
(
E U ( pR x + p [q − x ] − c ( q ) ) , )
where the utility function U is increasing and concave ( U ′ > 0, U ′′ < 0 ).
E (U ′ ( π ) [ p − c ′] ) = 0 .
( (
E (U ′ ( π ) [ p − c ′] ) ≤ E U ′ π p =c ′ ) [ p − c′]) = U ′ (π ) ⎡⎣E ( p ) − c′⎤⎦ ,
p =c ′
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c′ (q * ) ≤ E ( p ) .
That is, net sellers in the wholesale market ( q > x ) tend to under-produce.
Note that an implication of the above results is that marginal costs are not
equalised across market participants and hence generation costs are not
minimised.
dE (U (π ) ) ∂E (U (π ) )
dx
=
∂x
(
= E U ′ (π ) ⎡⎣ pR − p ⎤⎦ . )
Suppose q > x and pR = E ( p ) (perfect arbitrage between wholesale and
retail market). Then, by similar argument to the one above,
( ) ( (
E U ′ (π ) ⎡⎣ pR − p ⎤⎦ ≥ E U ′ π p = pR ) ⎡⎣ p R
) (
− p ⎤⎦ = U ′ π p = pR ) ⎡⎣ p R
− E ( p ) ⎤⎦ = 0 .
( )
Conversely, when q < x , E U ′ (π ) ⎣⎡ pR − p ⎦⎤ ≤ 0 , and so a wholesale buyer
would want to decrease retail involvement.
Results
generators will want to integrate into supply (and suppliers into generation)
Extensions
retail prices vary with wholesale prices: no hedging motive for vertical
integration
Ref: Baldursson & von der Fehr, Journal of Environmental Economics and
Management, 48, 682-704, 2004.
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Observation: less trade in emission permits than might have been expected.
Note: ex ante and ex post refer to, respectively, before and after uncertainty is
resolved.
c ( a, k ) + p [1 − a − k − q ]
First-order condition:
ca ( a, k ) = p
Market equilibrium (in the aggregate trade must sum to zero) determines the
price of quotas:
∑ ∆q ( p; k ) = 0 .
i
e
i i
(( ( )
E u π − c k , a q − p ⎡⎣1 − a q − k − q ⎤⎦ ))
where π is profits net of cost of cleaning activities.
( )
ck k q , aq = E ( p ) .
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It follows that marginal cost is equalised across technologies (internal
efficiency) as well as firms (external efficiency). Note that this implies that, in
this case, the initial allocation of quotas does not matter for abatement.
Note that this implies that initial quota allocation matters for abatement.
Also, if quotas are distributed so that firms get either full quota or no quota at
all (cf. grand-fathering), then trade in quotas is less if firms are risk averse.
The table below defines four acts or prospects, A, B, C and D. There are
three states, with probabilities given in the top row. The following rows gives
outcomes for each act (expressed as amounts of money).
The decision maker shall choose between A and B, and between C and D.
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This may be seen in two alternative ways. First, without loss of generality,
u(0) = 0 and u(5) = 1 may be assumed. It is then easy to see that A has
higher expected utility than B if and only if u(1) < 10/11. Exactly the same
condition on u(1) is equivalent to C having higher expected utility than D.
Alternatively, the conclusion may be reached by applying the argument for the
independence axiom: if the last of the three states is realised, the outcome is
the same for A and B, as well as for C and D. Therefore, this state should be
irrelevant for the choice between A and B, as well as for the choice between C
and D. If the last state is ignored, A = C and B = D. Therefore, A should be
preferred to B if and only if C is preferred to D.
It may nevertheless be claimed that choices can only be rational if they are
consistent with the expected utility theorem (note that this terminology implies
that what many people intuitively find reasonable is characterised as
‘irrational’). However, if the above reasoning for the choices A and D is
deemed rational and consistent the arguments in support of the independence
axiom cannot be convincing.
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