Risk aversion and indifference curve, Microeconomics

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Risk Aversion and Income

- Variability in potential payoffs increases risk premium.

- Example:

A job has a .5% probability of paying $40,000 (utility of 20) and a 5 percent chance of paying 0 (utility of 0).

* The expected income is $20,000, but expected utility falls to 10.

Expected utility = .5u($) + .5u($40,000)

= 0 + .5(20) = 10

* The certain income of $20,000 has a utility of 16.

* If person is required to take the new position, the utility of them will fall by 6.

* The risk premium is $10,000 (that is they would be willing to give up $10,000 of the $20,000 and have same E(u) as the risky job.

* Thus, it can be said that greater the variability, greater the risk premium.

* Indifference Curve

- Combinations of the3 expected income & standard deviation of income which yield the same utility.

1808_risk aversion.png

2239_risk aversion1.png

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