Utility Theory and Risk Attitudes

In general, if managers are faced with two alternative projects of equal expected return but different coefficients of variation of risk, it would give rise to three possible attitudes towards risk.

1.       Most managers may generally prefer the less risky project. They are called risk­-averters.

2.       Some may choose the more risky project i.e., are risk-seekers or risk lovers.

3.       Some may be indifferent to risk i.e., are risk-neutral. Any investment is equally preferable to them.

The principle of diminishing marginal utility of money explains this behaviour. The Figure shows that Rs 10,000 of money or wealth gives 2 utils (unit of measurement of utility) of utility to an individual (point A). While Rs 20,000 provides 3 utils (point B), 4 utils (point C), or 6 utils (point D) of satisfaction for curves Ud, Uc and Ui, respectively. The concave total utility curve (Ud) less than doubles the utility of the individual with a doubling of the money. A doubling of income doubles the utility in case of a straight line total utility money curve (Uc). Finally, if the total utility of money curve is convex (Ui) doubling of income more than doubles the utility, i.e., the marginal utility of money increases. 

Most individuals are risk averters because their marginal utility of money diminishes (i.e., they face a concave total utility curve). A risk averter would not accept a fair bet a risk-neutral individual would be indifferent to it, while a risk seeker would accept even some unfair bets. In managerial decisions subject to risk, a risk-averse manager seeks to maximise expected utility rather than monetary returns. 

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