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UNC-Chapel Hill ECON 410 - Study Guide

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Slide 1Econ 410: Micro TheoryPreferences Toward RiskMonday, October 1st, 2007Slide 2Plan for Today Chapter 4 Quiz Debrief Upcoming Exam Details Preferences toward risk Risk neutral and risk-loving individuals Accounting for Risk Aversion Risk Premiums Income VariabilitySlide 3Chapter 4 Quiz Debrief Multiple Choice, #7Slide 4Exam Details The midterm exam will be held next Monday, October 8th Covers material through section 5.2 of the text Exam Format 10-15 multiple choice questions 5-7 mathematical and graphing problems Studying Tips Re-do old quizzes and problem sets Course objectives handouts Review – Friday, October 5th Come prepared!Slide 5Recall from last time… People can be known as risk averse, risk neutral, or risk loving, depending upon their attitudes towards risk. A risk averse individual… Prefers a certain given income to a risky income with the same expected value Has a diminishing marginal utility of income For a risk averse person, losses (in terms of decreased utility) are more important than risky gainsSlide 6Risk Neutrality A person is said to be risk neutral if they show no preference between a certain income, and an uncertain income with the same expected value For risk neutral people, the marginal utility of income is constant Example – If Lisa were risk neutral, herexpected utility for the risky option wouldbe the same as her utility for the riskless job. E(I) = (0.5)($10) + (0.5)($30) = $20 E(U) = (0.5)(6) + (0.5)(18) = 12 This is the same as the riskless cafeteriaincome of $20 with utility of 12Slide 7Risk NeutralityIncome ($)10 20Utility0306AEC1218Lisa is risk neutraland is indifferentbetween certain events and uncertain eventswith the same expected income.Slide 8Loving Risk A person is said to be risk loving if they show a preference toward an uncertain income over a certain income with the same expected value Examples: Gambling, some criminal activities For risk-loving people, the marginal utility of income is increasing Example – If Lisa loved risk… E(I) = (0.5)($10) + (0.5)($30)= $20 E(U) = (0.5)(3) + (0.5)(18) = 10.5Slide 9Loving RiskIncome ($)Utility010 20 30Lisa is risk loving because she would prefer the gamble to a certain income.3AEC818F10.5Risky OptionSlide 10Risk Premium Recall that people are generally considered to be risk averse The marginal utility of income for a risk averse person is decreasing The risk premium is the maximum amount of money that a risk-averse person would pay to avoid taking a risk The risk premium depends on the risky alternatives that people face The greater the risk (or variability of income), the more people will pay to avoid itSlide 11Risk Premium Example Again suppose Lisa’s choices are:  A guaranteed cafeteria job that pays $20 A risky hall monitor job with payouts of $10 and $30 with equal probability As in the last class, assume Lisa is risk averse: Expected Income = $20 Expected Utility = 14 What amount would Lisa pay to avoid this risk?Slide 12Risk Premium Example Point E shows the risky scenario A utility of 14 can be obtained with certain income of $16 Lisa would be willing to pay up to $4 (20 – 16) to avoid the risk of uncertain income, the risk premium Line BE illustrates this graphicallyEIncome ($)Utility010 16 20101830402014ABCDRisk PremiumSlide 13For next time… Please read section 5.3 in your textbook Don’t Forget Your midterm exam is coming up on Monday, October 8th. Be sure to prepare questions for the review session on


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UNC-Chapel Hill ECON 410 - Study Guide

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