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

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?

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

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

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