ADMS 3300 Lecture Notes - Lecture 9: Exponential Function, Risk Aversion, Exponential Utility

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Risk-aversion can be understood as a utility function, which can be presented as an upward sloping, concave curve (opening downward). On the graph, . 75 has a utility value of . 75. So losing . 75 would feel like losing . 75. A typical utility curve is upward sloping and concave (the curve opens downward). An upward sloping utility curve makes fine sense: it means that more wealth is better than less wealth, everything else being equal. Concavity in a utility curve implies that an individual is risk-averse: generally, would trade a gamble for a sure amount that is less than the expected value of the gamble, shies away from gambling. A convex (opening upward) utility curve indicates risk seeking behavior: eager to enter into a gamble, overestimates values of winning. Risk-neutral is reflect by a straight line. Ignores risks: maximizing emv = maximizing expected utility. Expected utilities make it possible to rank these investments in order of preference.

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