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Econ 9 - 1 Preference Toward Risk 1 14.01 Principles of...

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Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY]. 1 1 Preference Toward Risk 14.01 Principles of Microeconomics, Fall 2007 Chia-Hui Chen September 26, 2007 Lecture 9 Preference Toward Risk, Risk Premium, Indifference Curves, and Reducing Risk Outline 1. Chap 5: Preference Toward Risk 2. Chap 5: Risk Premium 3. Chap 5: Indifference Curve 4. Chap 5: Reducing Risk: Diversification 1 Preference Toward Risk - Risk Averse / Neu- tral / Seeking (Loving) Three different kinds of behaviors: Risk Averse (Figure 1) Facing two payoffs with the same expected value, prefer the less risky one. Diminishing marginal utility of income. Relation between the utility of expected value and expected utility u ( E ( x )) > E ( u ( x )) . Example. u ( x ) = ln x. Risk Neutral (Figure 2) Facing two payoffs with the same expected value, feel indifferent. Linear marginal utility of income. Relation between the utility of expected value and expected utility u ( E ( x )) = E ( u ( x )) .
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Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY]. 2 2 Risk Premium u(x) 3 2.5 2 1.5 1 0.5 0 x 0 1 2 3 4 5 6 7 8 9 10 Figure 1: The Utility Function of Risk Averse. Example. u ( x ) = x. Risk Seeking (Figure 3) Facing two payoffs with the same expected value, prefer the riskier one.
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