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