8a. Decisions under Uncertainty Flashcards
What is “risk averse”?
unwilling to make a fair bet
What is “risk neutral”?
indifferent about making a fair bet
What is “risk preferring”?
willing to make a fair bet
What are the 3 risk attitudes?
- risk averse
- risk neutral
- risk preferring
What are the risk attitudes reflected in?
Risk attitudes are reflected in the curvature of the utility function
What risk attitude does this DIG show?
Risk-neutral
What risk attitude does this DIG show?
Risk-Preferring
What risk attitude does this DIG show?
Risk-Averse
What would a risk averse individual be willing to do when it comes to risk?
Someone who dislikes risk. Utility function is concave.
Willing to pay a RISK PREMIUM to get rid of risk.
-> A risk averse person does not take a fair bet but is willing to pay to get rid of the risk
What would a risk neutral individual be willing to do when it comes to risk?
Someone who is risk neutral has a constant marginal utility of wealth
- Each extra dollar of wealth raises utility by the same amount as the previous dollar
- The utility curve is a straight line in a utility and wealth graph.
A risk-neutral person chooses the option with the highest EV, because maximizing expected value maximizes utility
Individuals or firms who dislike risk can transfer the risk onto an _____________
Individuals or firms who dislike risk can transfer the risk onto an INSURANCE COMPANY
What would full insurance cover in the case of a bad event?
Full insurance will cover the entire amount of the loss if the bad event occurs
When is insurance said to be “fair”?
Seller: Fair Insurance
Premium = probability of the loss * value of the reimbursement
Insurance premium is fair when insurance breaks even
-> the EV with or without insurance is the SAME
If a person is risk averse, they would buy the full insurance if the premium is _____
If a person is risk averse, they would buy the full insurance if the premium is FAIR
