Risky Choices

and Risk
Aversion
Chapter 18

Slides by Pamela L. Hall

Western Washington University
©2005, Southwestern
 Introduction
 A pyramid scheme is a fraudulent system of making money
that requires an infinite stream of new investors for success
 Recruits give money to recruiters and then enlist fresh recruits to
give them money
 Such a scheme is called a pyramid scheme because it is the shape
of a pyramid
 A similar scam is a Ponzi scheme
 Named after Charles Ponzi who defrauded people in 1920s
• By getting people to invest in something for a guaranteed rate of return
 Used money of later investors to pay off earlier ones

 The lesson?
 Beware of any certain high rate of return
• Nothing is certain but uncertainty

2
 Introduction
 General theory of agent choice under certainty cannot be
employed for investigating optimal decisions with risky
outcomes
 Actual outcomes that occur in an uncertain world depend on their
probability of occurring
 Based on both subjective and objective probabilities, we
define risky alternatives (called states of nature)
 Given alternative states of nature, we define the
Independence Axiom
 Precludes states that will not happen from impacting household
preferences
 Given this Independence Axiom, we develop expected utility
function as an interval measure of utility
3
 Introduction
 We define households’ risk preferences in terms of
preferences
 Risk-averse
 Risk-seeking
 Risk-neutral
• Given a household’s risk preference, we develop concept of certainty
equivalence along with its implications for insurance
 We also develop concepts of actuarially fair insurance and
asymmetric information associated with insurance
 Aim in this chapter is to introduce concepts of risk and
uncertainty
 Investigate impacts they have on agents’ decisions
 Expected utility is extensively used by applied economists
as a tool for investigating this impact
4
 Probability
 A household’s decision regarding going to a movie this weekend has
some probability associated with it
 Even if household plans to go, something unexpected may occur and it
would not go
 Household will not go to movie if its opportunity cost of going rises to
point where cost of going outweighs benefit
 As household’s opportunity cost increases, probability of going to movie
decreases
 Probability is a measure of likelihood an outcome will occur
 An outcome could be some level of income, amount or quality of a
commodity, or a change in price
• If an outcome cannot happen, probability = 0
• If an outcome is certain to occur, probability = 1
 In previous chapters, we assumed probabilities of all outcomes were
either 0 or 1

5
 Subjective Probability
 Where a household has a perception that an event
will occur
 Household’s perception is based on
• Conditions of current market prices
• Its preferences
• Its income
 Any changes in these conditions will alter
household’s perceptions
 Households with different preferences will have different
perceptions
• Results in different subjective probabilities by individual
households through time and across various households

6
 Objective Probability
 Frequency with which certain outcomes will occur
 Objective probability of an outcome can be measured
from past experiences
 For example, if it is observed over some time
interval that a household goes to movies once
every 4 weeks
 Probability of going to movie on any weekend is ¼ or
25%
• An objective probability, measured by frequency of occurrence
 Depends on past household behavior

7
Mutually Exclusive Probabilities
 Both subjective and objective probabilities are mutually exclusive
 Only one outcome will occur
• For example, a household will either go to the movies this weekend or not
 Probabilities associated with each possible outcome always add up to 1
 If ¼ is probability household goes to the movies, then ¾ is probability it will
not
• These possible outcomes exhaust all possible outcomes
 Given mutually exclusive nature of these probabilities
 Probabilities sum to 1
 In general, assuming a finite number of outcomes, k

 Where j is probability of outcome j occurring

8
 States of Nature
 In making future consumption plans, a household will
consider probability of possible outcomes
 In determining these probabilities, household may use a
combination of subjective and objective probabilities
 Household is faced with choosing alternatives with uncertain
outcomes by means of known probabilities
 Each risky alternative is called a state of nature or lottery, N
• Defined as a set of probabilities, summing to 1, with a probability
assigned to each outcome
 For example, state of nature associated with our household
movie choice is (¼, ¾)
 If probability of going to movies was ¾ and not going was ¼, state of
nature would be reversed, (¾, ¼)

9
 States of Nature
 In general, a state of nature is a set of probabilities associated with all k
outcomes
 Consistent with previous chapters, we assume households are rational
when facing these states of nature with a preference relation
 Outcomes could be in any form
 Including consumption bundles, money, or an opportunity to participate in
another state of nature (called a compound lottery)
 Fundamental difference between commodities and states of nature
 Commodities can and generally are consumed jointly
• Examples are driving and listening to radio
 States of nature, by their definition of being mutually exclusive, cannot be
consumed jointly
• Either one state of nature exists or another
 For example, a household cannot have a 25% probability of going to the movies and a
75% probability of going to the movies at the same time
• Idea of being unable to jointly consume two or more states of nature is a
fundamental assumption of many theories dealing with choice under uncertainty
 Summarized by Independence Axiom 10
 Independence Axiom
 If N, N', and N" are states of nature, then N is weakly preferred over N' if and
only if

 Preference a household has for one state of nature, N, over another state, N'
 Should be independent from other states of nature, say N"
 For example, assume N is a state of nature where probability of getting a cola drink
is 1
 N' is a state where getting an un-cola drink has a probability of 1
 N" is a state where getting water has a probability of 1
• Amount of water a household may receive should not influence preferences for cola or uncola
• Household does not end up with any water, so it should not influence choice between cola and
un-cola
 Under these alternative states, only one of three possible states will occur
 Either household will receive cola, un-cola, or water, but it will not jointly receive these drinks
 Preference between cola and un-cola should not be influenced by amount of water in
another state of nature
• However, increasing amount of water in N" will influence preference between cola and water and
preference between un-cola and water

11
 Expected Utility Function
 Suppose probability of a candidate for governor supporting
environmental issues once elected (state of nature) varies by candidate
 Only one state of nature will actually occur
 However, there is a probability associated with which state of nature will
occur
 Utility of environmentalists will vary depending on which candidate gets
elected
 Average (expected) utility from election is the sum of utilities for each
candidate weighted by associated probability of being elected
 Based on Independence Axiom, utility function for choice under
uncertainty is additive for consumption in each possible state of nature
 For all possible states of nature, utility from consumption in one state of
nature is added to utility from consumption in another state
• Called expected utility function or von Neumann–Morgenstern utility
function)

12
 Expected Utility Function
 Specifically, for two possible states of nature,
expected utility function is

 Where U is utility function associated with

contingent commodity bundles x1 and x2
consumed in states of nature 1 and 2,
respectively
 1 and 2 are respective probabilities of states of
nature occurring
• 1 + 2 = 1
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 Expected Utility Function
 A contingent commodity is a commodity whose level of
consumption depends on which state of nature occurs
 Expected utility function is weighted sum of utility from consumption
in the states of nature
• Where weights are probabilities of states occurring
 If only one of the states of nature occurs, say state 1, then 1 = 1 and
2 = 0
• Utility function reduces to

 Standard utility function used in previous chapters, with certainty assumed

• With uncertainty, probabilities are 0 < (1, 2) < 1
 Utility function represents average or expected utility given alternative
possible states of nature

14
 Risk Preference
 Variability in outcomes of some state of nature when probability of each
outcome is known is called risk
 Generally, statistical concept of variance is employed as a measure of
risk
 Variance is a measure of spread of a probability distributionmeasures
variability in outcomes
• The greater the variance and thus the variability in outcomes, the greater is the
risk
 For example, for a salaried employee the state of nature associated with
receiving a fixed salary per month is risk free
 It has no variability, no risk, and a variance of 0
 In contrast, an employee working on commission has some risk
• The larger the variability in salary, possibly measured in terms of its variance, the
greater the risk

15
 Risk Preference
 In general, unless compensated for risk
exposure
 Households appear to have an aversion to risk
 In an effort to reduce this risk exposure, they
will attempt to shift risk onto another agent
 Purchasing insurance is a form of shifting risk
• Its prevalence suggests risk aversion is common not
only among households but also among firms

16
 Risk Aversion
 In a game of tossing a coin, if it is heads a household will receive $5 and if it is tails it must
pay $5
 Expected value of game is ½(5) + ½(-5) = 0
• Called actuarially fair
 Actuarially fair games
 Games in which expected values are zero
 Cost of playing a game is equivalent to game’s expected value
 If instead payoff for heads is increased to $15, expected value would be
 ½(15) + ½(-5) = 5
• A $5 cost of playing the game would reduce expected payoff to zero, which is actuarially fair
 In terms of risk preferences, a household has risk-averse preferences if it refuses to play
actuarially fair games
 A risk-averse household would generally refuse to play these games
• Unless there is some utility in actual process of playing and potential loss from playing is relatively small
• It would prefer its current certain state to a risky state with a possible loss in happiness
 Some individuals play actuarially unfair games
 Expected value is negative
• For some individuals who play slot machines or state lotteries, fun of playing and dreams of winning yield
utility in excess of small cost of playing

17
 Concave Utility Function
 Risk-averse households would generally prefer a
certain salary
 Versus a variable salary based on sales with an expected
value equivalent to certainty salary
 A risk-averse household will not play actuarially fair
games
 For this household winning the game increases utility by
a lesser degree than losing reduces it
• Such a household prefers its current level of wealth over variance
in wealth associated with an actuarially fair game
 Even though payoffs, in terms of resulting expected wealth, are the
same

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 Concave Utility Function
 Mathematically, for two possible states of nature, risk
aversion may be stated as
 U(1W1 + 2W2) > 1U(W1) + 2U(W2)
• Where W1 and W2 are levels of wealth resulting from possible outcomes
1 and 2, respectively
 Level of utility associated with expected wealth, U(1W1 + 2W2), is
greater than state of nature resulting in expected utility of wealth,
1U(W1) + 2U(W2)
 If outcomes were an employee’s salary, a risk-averse
employee would prefer state of nature with certain salary
resulting in U(1W1 + 2W2)
 Over uncertain salary with an expected utility level of 1U(W1) +
2U(W2)
• Inequality is called Jensen’s inequality
 Defines concave function illustrated in Figure 18.1
19
Figure 18.1 Risk-averse
preferences

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 Concave Utility Function
 A zero level of wealth corresponding with U = 0 results from
a positive linear transformation of expected utility function
 Due to concave nature of utility function
 Weighted average of wealth levels, W1 and W2, yield lower expected
utility of wealth, 1U(W1) + 2U(W2), than utility of expected wealth,
U(1W1 + 2W2)
• Weights are probability of wealth levels W1 and W2 occurring
• 1 + 2 = 1
• 1 > 2 (in this case)
 Risk aversion is equivalent to a concave expected utility
function
 Implies diminishing marginal utility of wealth
• ∂2U/∂W2 < 0
 As wealth increases, marginal utility of wealth declines

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 Risk Seeking
 Some individuals may have risk-seeking preferences
 Also called risk-loving preferences
• Prefer a random distribution of wealth over its expected value
 Gravitate toward occupations with more variable income streams
• Examples are being self-employed, day-trading stocks, or working as a
commodities trader
 Some individuals are not only risk seeking in terms of their wealth, but
also in life itself
 Examples are race-car drivers, soldiers in special military forces, and
criminals
 Most individuals do not have such extreme risk-seeking preferences
 However, at least for small potential losses in income, many households
have some risk-seeking characteristics
• For example, many households engage in gambling
 Overall, households are generally risk averse when it comes to relatively
large potential losses
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 Risk Seeking
 Mathematically, risk seeking reverses inequality for
risk aversion
 For two possible states of nature, risk-seeking
preferences are defined as
 U(1W1 +2W2) < 1U(W1) + 2U(W2)
 As illustrated in Figure 18.2, for risk-seeking
preferences expected utility function is now convex
 Weighted average of wealth levels, W1 and W2, yield a
higher expected utility of wealth, 1U(W1) + 2U(W2), than
utility of expected wealth, U(1W1 + 2W2)
• Risk seeking is equivalent to a convex expected utility function
 Implies increasing marginal utility of wealth, ∂2U/∂W2 > 0
 As wealth increases, marginal utility of wealth increases 23
Figure 18.2 Risk-seeking
preferences

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 Risk Neutrality
 Intermediate between risk aversion and risk seeking is linear
expected utility function representing risk neutral preference
 Households with risk-neutral preferences are not concerned with
variation in wealth
• Only concern is expected value of wealth
 A risk-neutral household is indifferent between receiving a
certain income versus an uncertain income
 Provided expected income from uncertain outcome is equivalent to
certain income
 Considering two outcomes, a household is considered risk
neutral when utility of expected wealth is equal to expected
utility of wealth
 U(1W1 +2W2) = 1U(W1) + 2U(W2)

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 Risk Neutrality
 Risk-neutral preferences are depicted in
Figure 18.3
 Expected utility function is now linear
• Weighted average of wealth levels, W1 and W2, yield
same expected utility of wealth, 1U(W1) + 2U(W2),
as utility of expected wealth, U(1W1 + 2W2)
 Equivalent to a linear expected utility function
• Implies constant marginal utility of wealth, ∂2U/∂W2 = 0
 Marginal utility is constant at all levels of wealth

26
Figure 18.3 Risk-neutral
preferences

27
 Certainty Equivalence
 Amount of return a household would receive from a certain
outcome so it is indifferent between a risky outcome and this
certain outcome
 Specifically, given two uncertain outcomes
• U(C) = 1U(W1) + 2(W2)
 Illustrated in Figure 18.4
 At a level of utility 1U(W1) + 2U(W2), household is indifferent
between receiving C with certainty or receiving risky outcome, 1W1
+ 2W2
 Certain return is less than risky outcome
• Implies a risk-averse household is willing to trade some expected return
for certainty
• Definition of risk aversion can be equivalently defined as C < 1W1 +
2W2
 Inequality sign is reversed for risk-seeking preferences
 Inequality becomes an equality for risk-neutral preferences 28
 Insurance
 Insurance companies have developed to where
one can acquire an insurance policy against almost
any risky outcome
 Certainty equivalence underlies functioning of
insurance
 Households are willing to pay to avoid risky outcomes
• Maximum amount they are willing to pay is difference in expected
wealth and certainty equivalence of wealth, (1W1 + 2W2) - C
 Paying more than this difference would result in a loss of utility
 They will be willing to pay less than this amount in the form of
insurance premiums

29
Figure 18.4 Risk aversion and
certainty equivalence

30
 Optimal Level of Insurance
 Can determine a household’s optimal level of insurance, A*
 By assuming household has initial level of wealth, W,
 Faces risk of sustaining a loss, D, with probability 
 Household can reduce amount of loss by purchasing
insurance, A, at a cost of p per-unit decrease in D (per-unit
insurance premium)
 Purchasing a level of insurance A will reduce loss from D to D - A
 If outcome results in no loss occurring, household’s wealth is
• W - pA
 If a loss occurs, household’s wealth level is
• W – pA – (D – A)
 Initial wealth minus total cost of insurance and net loss
 Household’s expected wealth is
 (1 - )(W – pA) + [W – pA – (D – A)]
 Which reduces to W – pA - (D – A)
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 Optimal Level of Insurance
 Although any expected utility function representing
risk-averse preference can be employed, for
simplicity assume following logarithmic expected
utility function
 U = (1 - ) ln(W – pA) +  ln[W – pA – (D – A)]
 Can determine efficient level of insurance, A*, by
maximizing this expected utility function

 F.O.C. is
• ∂U/∂A = -p(1 - )(W – pA)-1 + p(1 - )[W – pA – (D – A)]-1 = 0

32
 Actuarially Fair Insurance
 Assume price of insurance is actuarially fair
 So insurance company has zero administrative costs, resulting in
only claim costs
 Insurance premium, pA, would then be equal to company’s
cost of claims, A
 p = , and F.O.C. becomes
• -(1 - )(W - A)-1 + (1 - )[W - A – (D – A)]-1 = 0
• (W - A)-1 = [W - A – (D – A)]-1
 Equality will hold when A* = D

 If insurance is actuarially fair, a risk-averse household

maximizing expected utility will fully insure against all losses
 Household’s wealth is then W - pA, regardless if loss D occurs
 Wealth is equivalent to household’s expected wealth
• W – pA* - (D – A*)
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 Actuarially Unfavorable
Insurance
 In general, as a result of asymmetric information, insurance
is actuarially unfavorable rather than fair
 Premium paid by household will be higher than expected loss, pA >
D
• Household’s wealth with insurance will be less than its expected wealth
 W – pA* < W - D
 Household will not fully insure against all losses but instead will be
willing to accept some risk

 Actuarially unfavorable insurance implies p > , given A  D

 A rational household will not overinsure
 Specifically, rearranging F.O.C. gives
 [p(1 – )]/[(1 – p)] = [W – pA]/[W – pA – (D – A)] > 1
 With p > , the ratio p(1 - )/ (1 - p) > 1
• Yields the inequality
34
 Actuarially Unfavorable
Insurance
 The more insurance is actuarially unfavorable, the less insurance will be
purchased
 However, as long as difference in premium and expected loss is below
maximum amount a household is willing to pay for avoiding risky outcomes
• It will purchase insurance
 pA – pD < W - D – C
 pA < W - C
 For a household to be willing to purchase insurance, insurance premium must be
less than difference in initial risky wealth and certainty equivalence
 As an example, farmers are generally reluctant to purchase crop
insurance against crop losses from adverse weather
 Premiums for such insurance are generally based on current prices for
determining loss value of crop
• However, any upward price response, given decline in yield, will mitigate any
losses
 Can result in premiums exceeding expected losses to point where crop insurance is not
purchased

35
Actuarially Favorable Outcomes
 If an uncertain state is actuarially favorable, a risk-
averse household will also accept some risk
 A life free of failures will not maximize utility
 Actuarially favorable outcomes
 Assets where expected value is positive or cost of asset
is less than asset’s expected value
• An asset is the title to receive commodities or monetary returns
at some period in time
 If returns are in form of commodities, asset is called a real asset
 Example: a stamping machine for fabricating automobile
fenders
 Assets yielding monetary returns are called financial assets
 Example: Stock in a company providing a monetary return in
form of dividends
36
Actuarially Favorable Outcomes
 Can demonstrate willingness of households to take on some risk by considering
two assets, one certain, or risk free, and the other risky
 A risk-free asset is one that pays a certain fixed return
• In general, U.S. Treasury bills are considered a risk-free asset
 Let rC be rate of return for certain asset and let r1 and r2 be two possible rates of
return on risky asset
 Probability of r1 occurring is , so (1 - ) is probability of outcome r2
 Assume mean return of risky asset exceeds return of certain asset
 r1 + (1 - )r2 > rC
• Otherwise, risk-averse households would never invest in risky asset
 Let R and C denote proportion of wealth invested in risky and certain assets,
respectively
 Assume all wealth is invested in these two assets, so R + C = 1
 Objective of a household is to determine optimal amounts of wealth to invest in
the two assets
 Household has a probability  of earning a (RWr1 + CWrC) return and a probability of
(1 - ) of earning a (RWr2 + CWrC) return

37
Actuarially Favorable Outcomes
 Assuming a logarithmic expected utility function, a household
is interested in maximizing its return for a given level of wealth

 Taking a linear transformation by subtracting ln W yields

 Incorporating constraint into expected utility function yields

 F.O.C. is

38
Actuarially Favorable Outcomes
 Assume household is unwilling to take any
risk, so R = 0
 F.O.C. reduces to

39
Actuarially Favorable Outcomes
 If expected rate of return on risky asset is the same as the certain return
 By definition of risk aversion, a risk-averse household will not invest in risky
asset
 When expected rate of return is greater than certain return, R > 0, risk-
averse households will accept some risk
 At the point where returns are greater than the certain return for all
possible outcomes, R = 1
 Households will invest only in risky asset
• For two possible outcomes, this occurs where both r1 and r2 are greater than rC
 This example of a risk-averse household willing to accept some risk is
an exercise in diversification
 In general, considering many assets, as long as assets are not perfectly
correlated, there are some gains from diversification
• Households will have a portfolio of assets for maximizing their expected utility
 Overall riskiness of this portfolio depends on their degree of risk aversion
 In general, the greater the degree of risk aversion the less risky will be the portfolio

40
 Risk-Aversion Coefficient
 Arrow-Pratt risk-aversion coefficient, 
 A measure of degree of risk aversion
 Defined in terms of expected utility function
•  = -U"/U'
 Based on curvature of expected utility function
 For a risk-neutral household, expected utility function is linear
 U" = 0, which results in  = 0
 A risk-averse household will have a concave expected utility function
indicated by U" < 0
 The more risk averse a household, the more concave is the function
• Thus, the larger will be -U" and 
• For an extremely risk-averse household,  = 
 Such households will always fully insure against any risk regardless of the price
 Examples are an individual with major depressive disorder who will not get out of
bed or individuals with a particular phobia such as flying or driving

41
 Risk-Aversion Coefficient
 Similarly, a risk-seeking household will have
a convex expected utility function with U" > 0
 For an extremely risk-seeking household,  = -
• Such households would not insure against any risk
 An example is a suicide bomber

 Note that second derivative, U", is divided by

U'
 Risk-aversion coefficient will not vary by a linear
transformation of utility function

42
 Risk-Aversion Coefficient
 Employing risk-aversion coefficient as a measure of risk
aversion provides a comparison across household wealth
levels
 Generally, it is assumed that wealthier households are willing to take
more risk than less-wealthy households
• Thus, as a household’s wealth increases, the risk-aversion coefficient
declines
 ∂/∂W < 0

 An example of a utility function representing decreasing risk

aversion is
 U = ln W
• Where risk-aversion coefficient is  = 1/W
 As wealth increases, aversion to risk declines
 ∂/∂W = -1/W2 < 0
 However, not all utility functions represent decreasing risk aversion
43
 Risk-Aversion Coefficient
 Risk-aversion coefficient can also be employed for
a comparison of risk preferences across
households
 For example, given two households A and B
 Household A would be more risk averse than household
B if A > B for all levels of household wealth
 Allows a partial ordering of households’ preferences from
households who least prefer a risky outcome to those
households who are less averse to risky outcome
• However, it is not a complete ordering
 If, for example, A > B for some but not all levels of wealth, then it
is not possible to state household A is always more risk averse than
household B
44
 State-Dependent Utility
 A household may derive utility from not only the monetary returns
 But also from states of nature that underline them
• Called state-dependent utility
 Given this expected utility function for a household, we can determine
utility-maximizing state of nature subject to a constraint on wealth
 Assume a household has a choice of two states of nature
 For example, state 1 could be running its own business and
 State 2 could be having a position in a large international firm
 Associated with each state is a set (bundle) of contingent commodities
 Each set is available only if the particular state occurs
• By representing these commodity bundles in terms of monetary values (W1 and
W2) we can determine level of wealth required for obtaining each bundle
• Like all commodities, contingent commodities have an associated price
 This price is the cost of a particular uncertain state of nature occurring with certainty so
that the associated contingent commodities may be received
 Example: Political lobbyist’s expenditures on legislators to assure passage of
some legislation
45
 State-Dependent Utility
 Let p1 and p2 be the price of receiving contingent
commodities associated with states 1 and 2,
respectively
 In purchasing one of these contingent commodities,
household is constrained by a given level of initial wealth,
W
• Thus, household’s contingent budget constraint is
 p1W1 + p2W2 = W
• Recall that only bundle W1 or bundle W2 can occur and be
consumed
 p1/p2 indicates market tradeoff between states 1 and 2
 Measures rate at which contingent commodities in state 2 can
be substituted for contingent commodities in state 1, holding
level of initial wealth constant
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 Actuarially Fair Prices
 Assume prices p1 and p2 are actuarially fair and market for contingent
commodities within alternative states is active with many buyers and
sellers
 Called well-developed markets
 If state 1 occurs with probability  and state 2 with probability (1 - )
 Market will reveal these probabilities set p1 =  and p2 = (1 - )
 Assuming the Independence Axiom and household expects state 1 to
occur with probability , expected utility associated with the two
contingent commodity bundles is
 U(W1, W2) = U(W1) + (1 - )u(W2)
• Household will attempt to maximize this expected utility, given its budget
constraint
 Lagrangian is

47
 Actuarially Fair Prices
 F.O.C.s are

 From these F.O.C.s we obtain

 Assuming actuarially fair markets for contingent commodities

 Results in U'(W*1) = U'(W*2), so W*1 = W*2

48
 Actuarially Fair Prices
 Thus, a risk-averse household facing actuarially fair
markets will be willing to pay for a state with
certainty
 Where final level of wealth is the same regardless of
which state occurs
• An example is market for insurance
 Where price for achieving a given state is the insurance premium
and the contingent commodity is the contingent insurance claim

49
 Actuarially Fair Prices
 With actuarially fair insurance markets, risk-averse households will fully
insure against possible losses
 Will purchase insurance up to point where level of wealth is same regardless
of whether state of nature involves a loss
• Illustrated in Figure 18.5
 Axes measure wealth for the two alternative states
 Certainty line is a 45 line from origin
• Measures same level of wealth regardless of which state of nature occurs
 Indifference curves measure equivalent level of expected utility to
certainty level associated with certainty line
 Points not on certainty line represent utility levels associated with some
uncertainty in which state of nature will occur
 A household’s budget constraint is represented by budget line W
 Every point on budget line represents actuarially fair probability of the two
states of nature occurring

50
Figure 18.5 Risk aversion in
state-dependent utility

51
 Actuarially Fair Prices
 A risk-averse household is unwilling to play an actuarially fair game
 Movements off certainty line on budget line will result in lower levels of utility
• For a risk-averse household to be willing to accept some risk, they must be
compensated in the form of additional wealth
 A risk-averse household has indifference curves that are convex to origin
 Point A is unobtainable with initial wealth W
 However, at point A

 Household can maintain same level of utility, but requiring less initial wealth
• By moving down along indifference curve
 Decrease in required initial wealth continues until point B is reached on certainty line
 Where wealth levels of the states are equal

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 Actuarially Unfair Prices
 If market is actuarially unfair, a risk-averse household may
choose to accept some risk
 For example, consider an unfair price ratio of p1/p2 < /(1 - )
 From F.O.C.s for expected utility maximization

 Assuming actuarially unfair condition p1/p2 < /(1 - )

• Results in U'(W*1) < U'(W*2)

 So, assuming diminishing marginal utility of income, W*1 > W*2
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 Actuarially Unfair Prices
 Thus, a risk-averse household facing
actuarially unfair markets will be willing to
accept some risk
 Since relative price of W1 is low compared with
actuarially fair price ratio
• Illustrated in Figure 18.6
 Low price results in budget line tilting outward
 Establishes a tangency with indifference curve to the
right of certainty line
 Results in risky outcome of W*1 > W*2

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Figure 18.6 Actuarially unfair
markets

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 Risk Seeking
 A risky outcome will also result if a household
is risk seeking
 Illustrated in Figure 18.7
 Risk-seeking household’s indifference curves
are concave from origin
 Implies expected value for a certain outcome
must be higher than any risky outcome before
household would be indifferent between
outcomes
• Results in a corner solution, point A
 Household prefers outcome with greater risk
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Figure 18.7 Risk-seeking preferences for
contingent commodities

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