Week 2 - Expected Utility Theory Flashcards
What is utility in a general sense?
Utility refers to the measure of satisfaction or happiness that a consumer derives from consuming goods and services.
What are the properties of utility
Utility has ordinal properties, but we can quantify the difference in a meaningful way e.g. utility 6 is better than utility 3 but utility 6 is not twice as good
What does the Expected Utility Theory assume?
It assumes that people choose between risky or uncertain prospects by comparing their expected utility values rather than just expected outcomes.
What is the ‘risk-averse’ risk preference?
Individuals who prefer a certain outcome over a risky one with the same expected return
They buy insurance policies
Describe the utility function of risk-averse people
They have a concave utility function, showing diminishing marginal utility
What is the ‘risk-seeking’ risk preference?
Individuals who prefer to take risks and would choose a risky option over a certain option even if the expected returns are the same or less
They buy lottery tickets
Describe the utility function of risk-seeking people
They have a convex utility function
What is marginal utility?
It refers to the additional satisfaction or utility that a person derives from consuming one more unit of a good or a service
What is diminishing marginal utility?
The marginal utility of a good decreases as its consumption increases
What is the ‘risk-neutral’ risk preference?
Individuals who are indifferent between risky and certain options as long as the expected returns are the same. Their utility function is linear.
What is certainty equivalent?
the amount of cash which would give the investor the same ‘satisfaction’ as having entered the lottery
What is risk premium?
the amount that a risk-averse person will pay to avoid taking a risk
