RISK AVERSION

Most· people are risk averse. This means more than that people dislike bad things happening to them. It means that they dislike bad things more than they like comparable good things. For example, suppose a friend offers you the following opportunity. He will toss a coin. If it comes up heads, he will pay you $1,000. But if it comes up tails, you will have to pay him $1,000. Would you accept the bargain? You wouldn’t if you were risk averse. For a risk-averse person, the pain of losing the $1.000 would exceed the pleasure from winning $1,000. Economists have developed models of risk aversion using the concept of utility, which is a person’s subjective measure of well-being or satisfactions, Every level of wealth provides a certain amount of utility, as shown by the utility function In Figure I. But the function exhibits the property of diminishing marginal utility: The more wealth a person has, the less utility he gets an additional dollar. Thus, in the figure, the utility function gets flatter as wealth increases. Because of diminishing marginal utility, the utility lost from losing the $) ,000 bet is more than the utility gained from winning it. As a result risk averse. Risk aversion provides the starting point for explaining various things we the economy. Let’s consider three of them: insurance, diversification, and the risk-return trade-off.

RISK AVERSION

RISKRISK AVERSION AVERSION

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