lecture 8 - risk aversion

Risk AversionEconomics 302 - Microeconomic Theory II: Strategic Behavior

Instructor: Songzi Du

compiled by Shih En LuSimon Fraser University

March 12, 2015

ECON 302 (SFU) Lecture 8 March 12, 2015 1 / 7

Objectives

1 Computing the expected value, expected utility and certaintyequivalent of a lottery over wealth.

2 The shape of the utility function for risk-averse, risk-neutral andrisk-loving agents.


Utility over Wealth

Recall that an agents expected utility from a lottery L withprobability p1 of outcome 1 yielding utility u1, p2 of outcome 2yielding u2, ..., pn of outcome n yielding un is:

p1u1 + p2u2 + ... + pnun

From expected utility theory, we know that under some assumptions,it is possible to assign ui so that the above function represents theagents preferences.

But we didnt say anything about how the ui s are assigned!

Today: look at lotteries over wealth, and make assumptions on theutility.


Definitions (I)

Suppose you have utility u() over wealth and a lotteryL = (p1, p2, ..., pn), where outcome i is wealth wi , for each i = 1, ..., n.

The expected value (EV) of L is:

E [L] =n

i=1

piwi

(Sometimes, we are instead interested in the expected change inwealth (relative to your original wealth) under a lottery, which may bea bet/project/lottery ticket/etc. I will refer to that as the expectedvalue of the bet/project/lottery ticket/etc. But the expected value ofa lottery will refer to the expected total wealth, as above.)

Your expected utility (EU) from L is:

E [u(L)] = p1u(w1) + p2u(w2) + ... + pnu(wn)


Definitions (II)

Your certainty equivalent (CE) for L is:

w such that E [u(L)] = u(w)

Youre indifferent between L and having the CE for sure.

Your risk premium for L is:

E [L] CE (L)

Exercise: You have utility over wealth u(w) =w and start with

$50. Consider a bet with probability 0.5 of winning $14, andprobability 0.5 of losing $14. Define the lottery associated with takingthe bet. Find the EV of the lottery and of the bet. Find your EU, CEand risk premium for the lottery. Would you take the bet?


Attitudes toward Risk

An individual is risk-averse if CE (L) < E [L] (i.e. E [u(L)] < u(E [L])).

An individual is risk-neutral if CE (L) = E [L].

An individual is risk-loving if CE (L) > E [L].

Sometimes, a lottery L is given, and you can define risk attitude withrespect to L.

If a specific lottery is not given, then the definitions above apply to alllotteries. For example, an individual is risk-averse if for any lottery L(where no outcome occurs with certainty), CE (L) < E [L].


Graphical Representation

Remember the following math definition: a function u() is (strictly)concave if u(tx + (1 t)y) > tu(x) + (1 t)u(y) for all t (0, 1)and x 6= y .If you view x and y as outcomes of a lottery L = (t, 1 t) overwealth, this just says u(E [L]) > E [u(L)].

In fact, you can show that this implication also holds for Ls withmore than two outcomes.

Therefore, risk-aversion u() is strictly concave.Under the assumption that u() is twice-differentiable, risk-aversion u() is strictly concave u() < 0.Similarly, risk-loving agents have strictly convex u(), i.e.,u() > 0.Risk-neutral agents have linear u(), i.e., u() = 0.


lecture 8 - risk aversion

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