ACTL1101 Lecture Notes - Lecture 6: Expected Utility Hypothesis, Risk Aversion, Utility
Document Summary
Economics of risk: risk arises from future uncertainty. We de ne risk as future uncertainty: expected value of a risk is called the pure premium. Actuaries used to modify the probabilities of future events before calculating the expected value to include a margin for risk (mainly in life insurance) Modern techniques tend to look at speci c risk measures, rather than tweaking expected values: variability is the range of possible outcomes of the risk. Consider two risks with the same expected value and one with more adverse extreme outcomes than the other. Often prefer the risk with the less extreme outcomes sometimes even if expected value is slightly larger. We need a model to explain this. Utility: sophisticated method to model decisions with risk: utility, utility u ( ) used in economics to represent preferences over alternatives, notation: An individual prefers x to y (x y ) if. That is, the alternative with higher utility is always preferred.
