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(ECON3016)
We will lose 6 if 6
E/(1-p1)
E/p1 X1
Introducing another lottery in Johns
example
Lottery A: Get 3125 for sure independently of illness state
(i.e. expected value= 3125). This is a lottery without risk
Lot. A
3125
Decreasing line with slope:
500 Lot. B
-p1/(1-p1) =-0.75/0.25=-3
3125
4000
3125/0.75 X1
Is the expected value a good criterion to
decide between lotteries?
One criterion to choose between two lotteries is to
choose the one with a higher expected value
U '( xi ) 0
Expected utility: The standard criterion to
choose among lotteries
n
EU piU ( xi ) p1U ( x1 ) p2U ( x2 ) ... pnU ( xn )
i 1
EU p1U ( x1 ) p2U ( x2 )
EU p1U ( x1 ) (1 p1 )U ( x2 )
dEU 0 p1U '( x1 )dx1 (1 p1 )U '( x2 )dx2
dx2 p1 U '( x1 )
* MRS
dx1 (1 p1 ) U '( x2 )
dx2
AsU '( x) 0 0 decrea sin g
dx1
Drawing an indifference curve
dx2 p1 U '( x1 )
*
dx1 (1 p1 ) U '( x2 )
d 2 x2 p1 U ''( x1 )
*
dx 12
(1 p1 ) U '( x2 )
Convexity means that the second derivative is positive
In order for this second derivative to be positive, we need
that U(x)<0
A risk averse individual has utility function with U(x)<0
What shape is the utility function of a
risk averse individual?
U(x)
X=money
U(x)>0, increasing
U(x)<0, strictly
concave
Examples of commonly used Utility
functions for risk averse individuals
U ( x) ln( x)
U ( x) x
U ( x) x where 0 a 1
a
U ( x) exp(a * x) where a 0
Indifference curves versus line with the
same expected values
U "( X ) 1
r( X )
U '( X ) X
Risk aversion decreases as wealth
increases
Risk Aversion
If utility is exponential
U(X) = -e-aX = -exp (-aX)
where a is a positive constant
Pratts risk aversion measure is
U "( X ) a 2 e aX
r( X ) aX a
U (X ) ae
Risk aversion is constant as wealth
increases
Willingness to Pay for Insurance
Consider a person with a current
wealth of 100,000 who faces a 25%
chance of losing his automobile worth
20,000
Suppose also that the utility function is
U(X) = ln (x)
Willingness to Pay for Insurance