RMI-2302 Lecture Notes - Lecture 4: Utility, Reservation Price, Opportunity Cost
26 Oct 2016
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Risk in business and society - notes 4. Von neumann and morgenstern proposed an index for measuring utility in situations involving risk for the decision-maker. Utility index is designed for predictive purposes. Allows to predict which of several choices a person would prefer and thus enables him to make decisions. Risk-averse - person who is always willing to accept a small cash-certain amount than the expected values of a bet. Risk seeker - person who demands an amount of cash-certain in excess of the expected monetary pay-off, utility function would be rising at increasing rate. Risk-neutral - one who is neutral between a cash-certain amount and a bet whose expected value is equal to that; linear utility function. Utility functions are usually a function of wealth. Each individual looks at the utility of their wealth in each potential outcome and chooses their action based on expected utility. Utility is increasing at a decreasing rate.
