Behavioural Economics 3: Choice under Uncertainty 3.2 - Attitudes to risk

Question 1

What are the three main attitudes to risk and how are they represented in utility functions?

Answer 1

1. Risk Averse (Risk Hating)

Prefers the certainty equivalent (CE) over the risky prospect.
Utility function is concave:
u′(x)>0, u′′(x)<0
CE < EV → Positive risk premium

2. Risk Neutral

Indifferent between the expected value and the risky prospect.
Utility function is linear:
u(EV)=EU
CE = EV → Zero risk premium

3. Risk Seeking (Risk Loving):

Prefers the risky prospect over the certainty equivalent.
Utility function is convex:
u(EV)<EU> EV → Negative risk premium</EU>

Question 2

What is the Certainty Equivalent (CE) and how is it calculated?

Answer 2

Question 3

What is the Risk Premium and how is it interpreted?

Answer 3

Question 4

How do utility function shapes relate to risk attitudes and certainty equivalents?

Answer 4