BEPP 305 Lecture Notes - Lecture 5: Risk Aversion, Relative Risk, Expected Utility Hypothesis

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skywolf653

7 Mar 2017

School

UPenn

Department

Business Econ & Public Policy

Course

BEPP 305

Professor

Tobacman

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Document Summary

1/26/17 lecture 5 notes: how to measure risk aversion & where you might use this (optimal level of coverage?) I(cid:373)pa(cid:272)t of be(cid:396)(cid:374)oulli"s ideas: the idea that utility can be quantifiable, but this interpretation is questionable. Modern utility theory: as lo(cid:374)g as you (cid:272)a(cid:374) (cid:449)(cid:396)ite do(cid:449)(cid:374) p(cid:396)efe(cid:396)e(cid:374)(cid:272)es that (cid:373)ake p(cid:396)edi(cid:272)tio(cid:374)s that alig(cid:374) (cid:449)ith (cid:272)hoi(cid:272)es, it"s (cid:862)as if(cid:863) people (cid:373)ake decisions, and maybe this is enough, conditions for this to work: Completeness- must be able to rank all possible preferences. Does(cid:374)"t (cid:374)e(cid:272)essa(cid:396)ily hold (cid:271)e(cid:272)ause you do(cid:374)"t ha(cid:448)e (cid:396)elia(cid:271)le (cid:396)a(cid:374)ki(cid:374)g. People are sensitive to context and are influenced by recent events. Transitivity- if you prefer a to b and b to c, then you prefer a to c. Independence- if you"(cid:396)e p(cid:396)ese(cid:374)ted (cid:449)ith a ga(cid:373)(cid:271)le a(cid:374)d you p(cid:396)efe(cid:396) a o(cid:448)e(cid:396) b, the(cid:374) fo(cid:396) a(cid:374)y ga(cid:373)(cid:271)le c, if you prefer a over c if you prefer b over c (regardless of what c is) Utility of outcome a cannot depend on some alternative.

Related Questions

Question 1. Suppose that a decision maker is confronted with a choice between (i) the certainty of a $200 gain and (ii) a gamble where there is a 0.40 probability that he will gain $600 and a 0.60 probability that he will lose $20. Moreover, suppose that the utilities he attaches to -$20, $200, and $600 are -5, 10 and 25 respectively. Which course of action will he choose?

(a) .The gamble, since the expected utility from the gamble is greater than O.

(b) The gamble, since the expected utility from the gamble exceeds that from the certainty of a $200 gain.

(d) The certainty 'of a $200 gain, since the expected utility from the certainty of a $200 gain exceeds that from the gamble.

(e) He will be indifferent between the two, since both actions yield the same expected utilities.

2. An increase in monetary gain of $1 is associated with smaller and smaller increases in utility as the monetary gain increases in size. People with utility functions of this sort are (a) risk neutral

(b) risk averters

(d) utilitarians

3. An increase in monetary gain of $1 is associated with larger and larger increases in utility as the monetary gain increases in size. People with utility functions of this sort are

(a) risk neutral

(b) risk averters

(d) utilitarians

Question 4. You are trying to decide whether or not to join your friends down at the local refreshment centre. Unfortunately, you have an economics exam tomorrow. You have tried to keep up with the assignments and believe that if you do not study any more you have a 0,8 chance of getting at least a 70 on the exam, If you are lucky, however, and the lecturer does not ask any of the material you are still confused about, you will get a 90 (20% chance). However, if you stay horne and study you have a 90% chance of getting an 85 and a l0%'chance of getting a 75, If you wish to maximize the expected points on this exam, what should you do?

Question 5. Bud Weiser's Neumann-Morganstern utility function can be represented by the following equation U = 9 + M - 0.01M^2 where U is utility and M is monetary gain (in thousands of dollars), He has the opportunity to invest $20,000 in The Bourbon Cowboy Bar and Grill. He believes that there is a 2/3 chance that he will lose his entire investment and a 1/3 chance that he will gain $30,000.

(i) If he makes the investment, what is his expected utility?

(ii) Should he make the investment?

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BEPP 305 Lecture Notes - Lecture 5: Risk Aversion, Relative Risk, Expected Utility Hypothesis

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