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RISK PREFERENCES:

Three alternative views concerning the choice between a risky outcome and a certain outcome -- risk aversion, risk neutrality, and risk loving. Some people prefer to avoid risk (risk aversion), others enjoy engaging in risk (risk loving), and still others are indifferent (risk neutrality). Most people are risk averse, which underlies the provision of insurance. Others who are risk loving are more inclined to gamble, play the stock market, and be entrepreneurs.
Different people have different views, perspectives, and preferences about risk. Some people enjoy a risky situation and others do not. This gives rise to three alternative risk preferences -- risk aversion, risk neutrality, and risk loving. Risk aversion is the preference for a certain outcome over a risky outcome. Risk loving is the preference for a risky outcome over a certain outcome. Risk neutrality is indifference between a certain outcome and a risky outcome.

These three alternatives can be more precisely defined based on the marginal utility of income. Marginal utility is the change in utility resulting from a given change in the consumption of a good. Marginal utility of income is then the change in utility resulting from a given change in income. The standard presumption is that marginal utility declines as more of a good is consumed, that is, decreasing marginal utility. As a general rule the marginal utility of income also declines with an increase in income, would gives rise to risk aversion. However, it can also increase or remain constant, leading to risk loving or risk neutrality.

The provision of insurance is motivated by the risk averse who are willing to pay for certainty and avoid risk. Gambling, entrepreneurship, and playing the stock market is frequently undertaken by risk loving individuals.

Marginal Utility of Income

Marginal Utility of Income
Marginal Utility of Income

Key to understanding risk preferences is the marginal utility of income. As a general concept, marginal utility is the change in utility resulting from a change in the quantity of a specific good consumed. Marginal utility of income is then the change in utility resulting from a change in income. Income in this case represents the consumption of all goods purchased by the income.

The standard view in consumed demand theory is that the marginal utility of income decreases with an increase in the quantity consumed. This gives justification for the negatively-sloped demand curve. This view also generally applies to the marginal utility of income. Decreasing marginal utility of income results in risk aversion. However, for some people the marginal utility of income can also increase, leading to risk loving. Or the marginal utility of income can remain constant, leading to risk neutrality.

The exhibit to the right can be used to illustrate the three marginal utility of income alternatives. At your leisure and discretion, click the [Decreasing], [Constant], and [Increasing] buttons to present each of the three alternatives.

The marginal utility of income is not necessarily an intrinsic, unchanging characteristic of a person (like eye color or DNA), but is likely to change as a person's individual circumstances change. That is, a person might have decreasing marginal utility of income over some ranges of income, then increasing marginal utility of income over other ranges, with constant marginal utility of income arising during the transition from one to the other.

Risk or Certainty?

The three risk preferences can be differentiated with a simple wager. Suppose that you have $100 of income and are confronted with a $50 wager on the flip of a coin. If the coin comes up heads, then you win $50 and thus have a total of $150. If the coin comes up tails, then you lose $50 and thus have a total of only $50. Risk preferences determine your willingness to decline the wager and keep the $100 of income that you have (certain income) or agree to the wager not knowing whether you will win or lose (risky income).

It is important to note that the income expected from the wager (so called expected income) is actually equal to certain income ($100). That is, because the coin has an equal chance of coming up heads or tails, if you undertake this wager 100 times, you can expect to win 50 times and lose 50 times. The loses exactly equal the wins and the income you can expect to end up with is $100. However, there is a difference between the utility or satisfaction generated by the certain income and that generated by an equal about of risky income.

Risk aversion is preferring the certain income over the risky income. Risk loving is preferring the risky income over the certain income. Risk neutrality is indifferent between the two.

Risk Aversion

The first and most prevalent preference toward risk is risk aversion. This occurs when a person prefers certain income over risky income and arises due to decreasing marginal utility of income. A person with decreasing marginal utility of income obtains less utility from the income won than the income lost. The utility from winning is exceeded by the utility from losing. Even though the expected income is equal to the certain income, the utility obtained from the certain income exceeds the utility obtained from the expected income. A risk averse person is better off not wagering.

Because a risk averse person obtains more utility from certain income than from risky income, it follows that a smaller amount of certain income generates the same utility as the risky income. This means that a risk averse person is actually willing to pay to avoid risk. This difference in income is termed the risk premium and is the maximum price that a risk averse person would pay for an insurance policy that eliminates the risk.

Risk Loving

The opposite preference toward risk is risk loving. This occurs when a person prefers risky income over certain income and arises due to increasing marginal utility of income. A person with increasing marginal utility of income obtains more utility from the income won than the income lost. The utility from winning exceeds the utility from losing. Even though the expected income is equal to the certain income, the utility obtained from the certain income falls short of the utility obtained from the expected income. A risk loving person is better off by wagering.

Because a risk loving person obtains less utility from certain income than from risky income, it follows that a larger amount of certain income generates the same utility as the risky income. This means that a risk loving person actually needs to be paid to avoid risk. Or in other terms, this is the price that a risk loving person would pay for the opportunity to engage in risk. A risk loving person seeks out risky situations, including gambling, entrepreneurial pursuits, and playing the stock market.

Risk Neutrality

The last of the three preferences toward risk is risk neutrality. This occurs when a person prefers risky income equally to certain income and arises due to constant marginal utility of income. A person with constant marginal utility of income obtains the same utility from the income won as the income lost. The utility from winning equals the utility from losing. Not only is the expected income equal to the certain income, the utility obtained from the certain income equals the utility obtained from the expected income. A risk neutral person is indifferent about wagering.

Because a risk neutral person obtains the same utility from certain income as from risky income, no payment is needed either to avoid risk or to engage in risk.

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RISK PREFERENCES, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2018. [Accessed: October 17, 2018].


Check Out These Related Terms...

     | risk | uncertainty | risk aversion | risk neutrality | risk loving | marginal utility of income | risk pooling | risk premium | economics of uncertainty |


Or For A Little Background...

     | economics | microeconomics | market | scarcity | efficiency | sixth rule of ignorance | marginal utility | paper economy | consumer demand theory |


And For Further Study...

     | public choice | economics of information | innovation | good types | market failures | financial markets | institutions | insurance | information | efficient information search | information search | asymmetric information | adverse selection | moral hazard | signalling | screening | rational ignorance | market failures |


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