Attitudes To Risk (easy - Notes Complete)

Question 1

3 attitudes to risk

Answer 1

Risk averse
Risk loving
Risk neutral

Question 2

Risk averse characteristics (2)

Answer 2

EV is preferred to the gamble (I.e a certain value>possibility)
Concave utility function

Question 3

Risk-loving consumer (2)

Answer 3

Random distribution preferred to the EV (possibility>certainty)

Convex utility function

Question 4

Risk neutral agent

Answer 4

Expected utility of wealth is utility of expected value

Doesn’t care about risk, only expected value.

Question 5

Risk diagrams axis’

Answer 5

Utility Y axis
Wealth X acis

Question 6

How to explain risk adverse diagram

Answer 6

Expected wealth U (E[W]) > Expected utility E [U(W)]

Which means risk adverse (expected value>gamble)
Since expected utility contains risk, and here we say we don’t value it so E[W] > E[U(W)]

(Look at annotated diagram notees for better graphical explanation of E[W] > E[U(W)]

Question 7

How to explain risk loving consumer

Answer 7

Expected wealth U (E[W]) < Expected utility E [U(W)]

Random distribution > expected value (certainty)

Question 8

How to explain risk neutral agent

Answer 8

Expected wealth U (E[W]) = Expected utility E [U(W)]

Question 9

EXPECTED UTILITY IS THE UTILITY OF THE GAMBLE (UNCERTAINTY)

EXPECTED UTILITY OF WEALTH REPRESENTS THE CERTAINTY

Question 10

For each 3 attitudes, describe what happens to marginal utility as wealth rises

Answer 10

Risk adverse - MU falls as wealth rises (concave curve shows this)

Risk loving - MU increases as wealth rises (convex)

Risk-neutral - MU constant (straight line)