MIT 14 01 - Lecture Notes (7 pages)

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Lecture Notes



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Lecture Notes

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Pages:
7
School:
Massachusetts Institute of Technology
Course:
14 01 - Principles of Microeconomics

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1 Preference Toward Risk 1 14 01 Principles of Microeconomics Fall 2007 Chia Hui Chen September 26 2007 Lecture 9 Preference Toward Risk Risk Premium Indi erence Curves and Reducing Risk Outline 1 Chap 5 Preference Toward Risk 2 Chap 5 Risk Premium 3 Chap 5 Indi erence Curve 4 Chap 5 Reducing Risk Diversi cation 1 Preference Toward Risk Risk Averse Neu tral Seeking Loving Three di erent kinds of behaviors Risk Averse Figure 1 Facing two payo s with the same expected value prefer the less risky one Diminishing marginal utility of income Relation between the utility of expected value and expected utility u E x E u x Example u x ln x Risk Neutral Figure 2 Facing two payo s with the same expected value feel indi erent Linear marginal utility of income Relation between the utility of expected value and expected utility u E x E u x Cite as Chia Hui Chen course materials for 14 01 Principles of Microeconomics Fall 2007 MIT OpenCourseWare http ocw mit edu Massachusetts Institute of Technology Downloaded on DD Month YYYY 2 Risk Premium 2 3 2 5 u x 2 1 5 1 0 5 0 0 1 2 3 4 5 x 6 7 8 9 10 Figure 1 The Utility Function of Risk Averse Example u x x Risk Seeking Figure 3 Facing two payo s with the same expected value prefer the riskier one Increasing marginal utility of income Relation between the utility of expected value and expected utility u E x E u x Example u x x2 2 Risk Premium Risk premium The maximum amount of money that a risk averse person would pay to avoid taking a risk Example Job Choice Assume that a risk averse person whose utility function corresponds with the curve in Figure 4 has two possible incomes Cite as Chia Hui Chen course materials for 14 01 Principles of Microeconomics Fall 2007 MIT OpenCourseWare http ocw mit edu Massachusetts Institute of Technology Downloaded on DD Month YYYY 2 Risk Premium 3 9 8 7 6 u x 5 4 3 2 1 0 0 1 2 3 4 5 x 6 7 8 9 10 Figure 2 The Utility Function of Risk Neutral 70 60 50 u x 40 30 20 10 0 0 1 2 3 4 5 x 6 7 8 9 10 Figure 3 The



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