What do we mean by “risk”?

JDN 2457118 EDT 20:50.

In an earlier post I talked about how, empirically, expected utility theory can’t explain the fact that we buy both insurance and lottery tickets, and how, normatively it really doesn’t make a lot of sense to buy lottery tickets precisely because of what expected utility theory says about them.

But today I’d like to talk about one of the major problems with expected utility theory, which I consider one of the major unexplored frontiers of economics: Expected utility theory treats all kinds of risk exactly the same.

In reality there are three kinds of risk: The first is what I’ll call classical risk, which is like the game of roulette; the odds are well-defined and known in advance, and you can play the game a large number of times and average out the results. This is where expected utility theory really shines; if you are dealing with classical risk, expected utility is obviously the way to go and Von Neumann and Morgenstern quite literally proved mathematically that anything else is irrational.

The second is uncertainty, a distinction which was most famously expounded by Frank Knight, an economist at the University of Chicago. (Chicago is a funny place; on the one hand they are a haven for the madness that is Austrian economics; on the other hand they have led the charge in behavioral and cognitive economics. Knight was a perfect fit, because he was a little of both.) Uncertainty is risk under ill-defined or unknown probabilities, where there is no way to play the game twice. Most real-world “risk” is actually uncertainty: Will the People’s Republic of China collapse in the 21st century? How many deaths will global warming cause? Will human beings ever colonize Mars? Is P = NP? None of those questions have known answers, but nor can we clearly assign probabilities either; Either P = NP or not, as a mathematical theorem (or, like the continuum hypothesis, it’s independent of ZFC, the most bizarre possibility of all), and it’s not as if someone is rolling dice to decide how many people global warming will kill. You can think of this in terms of “possible worlds”, though actually most modal theorists would tell you that we can’t even say that P=NP is possible (nor can we say it isn’t possible!) because, as a necessary statement, it can only be possible if it is actually true; this follows from the S5 axiom of modal logic, and you know what, even I am already bored with that sentence. Clearly there is some sense in which P=NP is possible, and if that’s not what modal logic says then so much the worse for modal logic. I am not a modal realist (not to be confused with a moral realist, which I am); I don’t think that possible worlds are real things out there somewhere. I think possibility is ultimately a statement about ignorance, and since we don’t know that P=NP is false then I contend that it is possible that it is true. Put another way, it would not be obviously irrational to place a bet that P=NP will be proved true by 2100; but if we can’t even say that it is possible, how can that be?

Anyway, that’s the mess that uncertainty puts us in, and almost everything is made of uncertainty. Expected utility theory basically falls apart under uncertainty; it doesn’t even know how to give an answer, let alone one that is correct. In reality what we usually end up doing is waving our hands and trying to assign a probability anyway—because we simply don’t know what else to do.

The third one is not one that’s usually talked about, yet I think it’s quite important; I will call it one-shot risk. The probabilities are known or at least reasonably well approximated, but you only get to play the game once. You can also generalize to few-shot risk, where you can play a small number of times, where “small” is defined relative to the probabilities involved; this is a little vaguer, but basically what I have in mind is that even though you can play more than once, you can’t play enough times to realistically expect the rarest outcomes to occur. Expected utility theory almost works on one-shot and few-shot risk, but you have to be very careful about taking it literally.

I think an example make things clearer: Playing the lottery is a few-shot risk. You can play the lottery multiple times, yes; potentially hundreds of times in fact. But hundreds of times is nothing compared to the 1 in 400 million chance you have of actually winning. You know that probability; it can be computed exactly from the rules of the game. But nonetheless expected utility theory runs into some serious problems here.

If we were playing a classical risk game, expected utility would obviously be right. So for example if you know that you will live one billion years, and you are offered the chance to play a game (somehow compensating for the mind-boggling levels of inflation, economic growth, transhuman transcendence, and/or total extinction that will occur during that vast expanse of time) in which at each year you can either have a guaranteed $40,000 of inflation-adjusted income or a 99.999,999,75% chance of $39,999 of inflation-adjusted income and a 0.000,000,25% chance of $100 million in inflation-adjusted income—which will disappear at the end of the year, along with everything you bought with it, so that each year you start afresh. Should you take the second option? Absolutely not, and expected utility theory explains why; that one or two years where you’ll experience 8 QALY per year isn’t worth dropping from 4.602056 QALY per year to 4.602049 QALY per year for the other nine hundred and ninety-eight million years. (Can you even fathom how long that is? From here, one billion years is all the way back to the Mesoproterozoic Era, which we think is when single-celled organisms first began to reproduce sexually. The gain is to be Mitt Romney for a year or two; the loss is the value of a dollar each year over and over again for the entire time that has elapsed since the existence of gamete meiosis.) I think it goes without saying that this whole situation is almost unimaginably bizarre. Yet that is implicitly what we’re assuming when we use expected utility theory to assess whether you should buy lottery tickets.

The real situation is more like this: There’s one world you can end up in, and almost certainly will, in which you buy lottery tickets every year and end up with an income of $39,999 instead of $40,000. There is another world, so unlikely as to be barely worth considering, yet not totally impossible, in which you get $100 million and you are completely set for life and able to live however you want for the rest of your life. Averaging over those two worlds is a really weird thing to do; what do we even mean by doing that? You don’t experience one world 0.000,000,25% as much as the other (whereas in the billion-year scenario, that is exactly what you do); you only experience one world or the other.

In fact, it’s worse than this, because if a classical risk game is such that you can play it as many times as you want as quickly as you want, we don’t even need expected utility theory—expected money theory will do. If you can play a game where you have a 50% chance of winning $200,000 and a 50% chance of losing $50,000, which you can play up to once an hour for the next 48 hours, and you will be extended any credit necessary to cover any losses, you’d be insane not to play; your 99.9% confidence level of wealth at the end of the two days is from $850,000 to $6,180,000. While you may lose money for awhile, it is vanishingly unlikely that you will end up losing more than you gain.

Yet if you are offered the chance to play this game only once, you probably should not take it, and the reason why then comes back to expected utility. If you have good access to credit you might consider it, because going $50,000 into debt is bad but not unbearably so (I did, going to college) and gaining $200,000 might actually be enough better to justify the risk. Then the effect can be averaged over your lifetime; let’s say you make $50,000 per year over 40 years. Losing $50,000 means making your average income $48,750, while gaining $200,000 means making your average income $55,000; so your QALY per year go from a guaranteed 4.70 to a 50% chance of 4.69 and a 50% chance of 4.74; that raises your expected utility from 4.70 to 4.715.

But if you don’t have good access to credit and your income for this year is $50,000, then losing $50,000 means losing everything you have and living in poverty or even starving to death. The benefits of raising your income by $200,000 this year aren’t nearly great enough to take that chance. Your expected utility goes from 4.70 to a 50% chance of 5.30 and a 50% chance of zero.

So expected utility theory only seems to properly apply if we can play the game enough times that the improbable events are likely to happen a few times, but not so many times that we can be sure our money will approach the average. And that’s assuming we know the odds and we aren’t just stuck with uncertainty.

Unfortunately, I don’t have a good alternative; so far expected utility theory may actually be the best we have. But it remains deeply unsatisfying, and I like to think we’ll one day come up with something better.

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