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Solution Expected Utility

The document presents a problem involving expected utility calculations for two scenarios with different utility functions. In the risk-averse case, the expected income is 50, the expected utility is 5, and the agent is willing to pay a risk premium of 25 to avoid the risk. In the risk-neutral case, the expected income remains 50, and the agent is not willing to pay anything to avoid the risk as the expected utility matches the utility of expected income.

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Minh Anh
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7 views3 pages

Solution Expected Utility

The document presents a problem involving expected utility calculations for two scenarios with different utility functions. In the risk-averse case, the expected income is 50, the expected utility is 5, and the agent is willing to pay a risk premium of 25 to avoid the risk. In the risk-neutral case, the expected income remains 50, and the agent is not willing to pay anything to avoid the risk as the expected utility matches the utility of expected income.

Uploaded by

Minh Anh
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

Exercise

Suppose that you have an utility function U(X) = X0,5

You have the possibility to win X1= 100 or X2=0


The probability to win X1 is P1=0,5, while the probability of winning X2 is P2=1-
P1

a. Compute expected income, expected utility and how much the agent is
willing to pay in order to avoid the risk.

Now repeat the same exercise, so you have the possibility to win X1= 100 or
X2=0 and P1=0,5, while P2=1-P1 but this time your utility function is U(X)= X

b. Compute expected income, expected utility and how much the agent is
willing to pay in order to avoid the risk.
1
2

Solution

• Actions or decisions involving a certain degree of uncertainty can lead to


different outcomes. Every outcome has a certain probability to happen.
• If individuals don’t care about the risk, in a uncertain situation they
decides according to the higher expected value
• However individuals do care about risk!
• So we should use the Theory of expected utility, according to which you
choose the option that provides you with the higher UTILITY, namely
the higher utility in “expectation term”

a. RISK ADVERSE CASE

UTILITY OF
EXPECTED
VALUE
U(E(X))

EXPECTED
UTILITY
E(U(X))

EXPECTED
INCOME

Expected income E(X)= P1*X1 +P2*X2

E(X)= 100*0,5 + 0= 50

Utility of expected income U(E(X))= 500,5 = 7,07

Expected utility E (U(X))= 0,5* U(X1)+ 0,5 *U(X2)= 0,5 *1000,5 + 0 + = 5


U(E(X))> E (U(X)) consistent with risk aversion

In fact 7,07> 5

Certain equivalent: X0,5=0,5*1000,5 à X*=100/4 à X*=25

Risk premium: E(X)-X*=50-25=25

Which is what you are willing to pay.

b. RISK NEUTRAL CASE

E(X)= 100*0,5 + 0= 50
U(E(X))= 50
U(E(X))= E (U(X)) consistent with the risk neutral utility, so you won’t
pay anything to avoid the risk

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