PREFERENCES TOWARD RISK
* Choosing Among Risky Alternatives
- Assume
- Consumption of a single commodity
- The consumer knows all probabilities
- Payoffs measured in terms of utility
- Utility function given
* Example
- A person who is earning $15,000 and receiving 13 units of utility from job.
- She is considering a new, but at the same time risky job.
* She has a 50 % chance of increasing her income to $30,000 and a 50% chance of decreasing her income to $10,000.
* She will evaluate the position by calculating expected value of the resulting income.
* The expected value of the new position is the sum of utilities associated with all her possible incomes weighted by probability that each income will occur.
* The expected utility can be given by:
- E(u) = (1/2)u($10,000) + (1/2)u($30,000)
= 0.5(10) + 0.5(18)
= 14
- E(u) of new job is 14 that is greater than current utility of 13 and therefore preferred.
* Different Preferences Toward Risk
- People can be
1) Risk averse
2) Risk neutral or
3) Risk loving