(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 188

CHAPTER 5 • Uncertainty and Consumer Behavior 163

Probability

F IGURE 5.1

OUTCOME PROBABILITIES FOR TWO
JOBS

0.2
Job 2
0.1
Job 1

$1000

$1500

$2000

The distribution of payoffs associated with Job
1 has a greater spread and a greater standard
deviation than the distribution of payoffs associated with Job 2. Both distributions are flat
because all outcomes are equally likely.

Income

graphically. (If there had been only two equally probable outcomes, then the
figure would be drawn as two vertical lines, each with a height of 0.5.)
You can see from Figure 5.1 that the first job is riskier than the second. The
“spread” of possible payoffs for the first job is much greater than the spread

for the second. As a result, the standard deviation of the payoffs associated
with the first job is greater than that associated with the second.
In this particular example, all payoffs are equally likely. Thus the curves
describing the probabilities for each job are flat. In many cases, however, some
payoffs are more likely than others. Figure 5.2 shows a situation in which
the most extreme payoffs are the least likely. Again, the salary from Job 1 has
a greater standard deviation. From this point on, we will use the standard
deviation of payoffs to measure the degree of risk.

Decision Making
Suppose you are choosing between the two sales jobs described in our original
example. Which job would you take? If you dislike risk, you will take the second
job: It offers the same expected income as the first but with less risk. But suppose we
add $100 to each of the payoffs in the first job, so that the expected payoff increases
from $1500 to $1600. Table 5.4 gives the new earnings and the squared deviations.

Probability
0.3

F IGURE 5.2

0.2

UNEQUAL PROBABILITY OUTCOMES

Job 2

0.1

Job 1

$1000

$1500

$2000

Income

The distribution of payoffs associated with Job 1
has a greater spread and a greater standard deviation than the distribution of payoffs associated
with Job 2. Both distributions are peaked because
the extreme payoffs are less likely than those near
the middle of the distribution.