Risk Aversion and Income
- Variability in potential payoffs increases risk premium.
* The expected income is $20,000, but expected utility falls to 10.
Expected utility = .5u($) + .5u($40,000)
= 0 + .5(20) = 10
* The certain income of $20,000 has a utility of 16.
* If person is required to take the new position, the utility of them will fall by 6.
* The risk premium is $10,000 (that is they would be willing to give up $10,000 of the $20,000 and have same E(u) as the risky job.
* Thus, it can be said that greater the variability, greater the risk premium.
* Indifference Curve
- Combinations of the3 expected income & standard deviation of income which yield the same utility.