Lecture 10 (End of Chapter Questions)

Question 1

What is CE? What is RP? What is Risk tolerance?

Answer 1

CE: Certain outcome that has the same expected utility as the lottery.

RP: How much of the expected value of lottery a would the DM give up to avoid the risk of the lottery.

Risk tolerance: R = 1 / r(x)

• r(x) = Arrow/Pratt measure
• The larger R the more the individual is able to tolerate risk

Question 2

How can you measure risk attitudes and which types of risk attitudes do we distinguish?

Answer 2

• Risk averse, risk neutral and risk prone
• Risk attitude is reflected by the strength and kind of the curvature

1. Absolute risk aversion coefficient: Arrow/Pratt measure -> r(x) = - u’‘(x) / u’(x)
2. Relative risk aversion coefficient: r*(x) = x * r(x)

Question 3

What are the differences between:

• absolute dominance
• statewise dominance
• Stochastic dominance

Answer 3

Absolute dominance: a dominates b in any case

Statewise dominance: a dominates b in each state

Stochastic dominance: The risk profile of a is always equal to and at least for one consequence above b

Question 4

When would you use dominance relationships? Why are they important?

Answer 4

• used when utility functions are unknown

Why important?