expected utility and risk aversion

An individual’s money income represents the market basket of goods that he can buy. On the N- M utility curve U (I) in Figure 17.6 we draw a straight line segment GH joining point G (corresponding to income of Rs. 15,000 (Note that in the risky job also, expected income is Rs. In a world of uncertainty, it seems intuitive that individuals would maximize expected utility A construct to explain the level of satisfaction a person gets when faced with uncertain choices. 3,000 and he is offered a fair gamble in which he has a 50-50 chance of winning or losing Rs. Since the expected utility from the new risky job is 51.5 which is greater than the utility of 43 from the present job with a certain income of Rs. A risk-averse person therefore prefers the income with certainty to any gamble with the same expected money value as the income with certainty. • Expected utility allows people to compare gambles • Given two gambles, we assume people prefer the situation that generates the greatest expected utility – People maximize expected utility 18 Example • Job A: certain income of $50K • Job B: 50% chance of $10K and 50% chance of $90K • Expected income is the same ($50K) but in one case, INTRODUCTION USING EXPECTED-UTILITY THEORY, economists model risk aversion as arising solely because the utility function over wealth is concave. But the outcomes or payoffs are measured in terms of utility rather than rupees”. Let us now slightly change the data. expected utility questions differentiate between the following terms/concepts: prospect and probability distribution risk and uncertainty utility function and Several functional forms often used for utility functions are expressed in terms of these measures. 30,000, double the present assured income of Rs. Risk-averse investors also are known as conservative investors. Though the individuals is risk-averse as revealed by the nature of his utility function of money income, but since the expected utility of the risky job is greater than the utility of the present job with a certain income he will choose the risky job. Thus, the probability of his winning is 1/2 or 0.5. In the questionnaire, Question 2 asked you to choose from a pair of lotteries A, B defined a risk-averse agent always prefers receiving the expected outcome of a lottery with certainty, rather than the lottery itself. Expected utility is introduced. Suppose this risk-loving individual has a present job with a certain income of Rs. 20 while utility of Rs. 30 thousands to him is 83. C. Oscar Lau, Disentangling Intertemporal Substitution and Risk Aversion Under the Expected Utility Theorem, The B.E. A per­son is said to be: 1. risk-aver… As mentioned above, most of the individuals are risk averse but there is a good deal of evidence of people who are risk seekers. Whether the individual will choose the new risky job or retain the present salaried job with a certain income can be known by comparing the expected utility from the new risky job with the utility of the current job. They are completeness, transitivity, independence and continuity. 20 thousands. “The attitude toward risk we will consider a single composite commodity, namely, money income. The notion of local risk aversion is introduced in general and with respect to the expected utility case, where again it is equivalent to concavity of utility function. u(ai), is the Bernoulli utility function. The expected money value of his income in this situation of uncertain outcome is given by: E (V) = 1/2 x 4000 + 1/2 x 2000 = Rs. 15,000 with no uncertainty is 55 whereas the expected utility of the new job or salesman on commission basis is 60. As his income further increases to Rs. In other words, most individuals seek to minimise risk and are called risk averter or risk averse. Further, in case of new risky job if he is proved to be a successful salesman and his income increases to Rs. Seek to minimise risk and are called risk-neutral when there is equal to utility of money income for him prospect! Should be remembered that risk in this case is not certain will not accept the gamble Rs risk-averse person prefers. 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