Attitudes Toward Risk
Autor: tjlavelle • February 6, 2016 • Course Note • 1,445 Words (6 Pages) • 653 Views
Attitudes toward Risk continued...
Risk Neutrality
Someone who is risk neutral does not have a positive or negative risk premium and they care only about the expected value of the gamble.
The risk neutral person will always choose the random prospect with the highest expected value.
We often model firms as being risk neutral but that may not be the case
We can quantify how someone feels about risk using the risk premium explanation
Risk can be used to compare how different individuals feel about risk
The higher a person's risk premium, the more risk averse they are
We can use this concept to see how attitudes about risk can change with given factors
things like level of wealth have effects on attitude toward risk
Explains why people buy insurance
1% chance that your $100k car will be destroyed
Your asset has an expected value of $99,000
1% * $0 + 99% * $100k = $99k
You have a risk premium of $2,000, so you would prefer the prospect of having a 1.0 chance of an asset that's $98k. That's a risk-free asset that is worth $98,000.
If insurance costs less than $2000 then you'll buy it.
Bernoilli
he was puzzled by the St. Petersburg paradox and wanted to explain the fact that people would not want to take a gamble that was extraordinarily attractive
Wanted to see what was going on in peoples minds
Moral Expectation - people don't think about money as an end but rather a means to an end. People look at all the possible outcomes and instead of just seeing them as monetary value they inpute the value of what they would win or lose to their state of happiness
The value of money gets smaller the more you have of it. $10 means more when you have $100 as opposed to when you have $10,000.
If you believe this then that's why people won't pay an infinite amount to play the SP game.
Expected Utility Model
Utility is your happiness metric.
It says that the utility of an outcome increases at a decreasing rate. Conversely as outcomes decline, your utility decreases at an increasing rate.
Marginal utility
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