The presentation provide a basic idea on people's attitude towards risk

1. Attitude towards Risk

2. • The underlying principles of making a choice in risky and uncertain
situation, namely, expected return and the degree of risk involved apply
equally well to other choices
• People’s preferences toward risk greatly differ. Most individuals generally
prefer the less risky situation (that is, the situation with less variability in
outcomes or rewards). In other words, most individuals seek to minimise risk
and are called risk averter or risk averse

3. • some individuals prefer risk and are therefore called risk-seekers or risk
lovers.
• Some other individuals are indifferent toward risk and are called risk-neutral.
• But it is important to note that these different preferences toward risk
depend on whether for an individual marginal utility of money diminishes or
increases or remains constant

4. • for a risk averse individual marginal utility of money diminishes as he has
more money, while for a risk-seeker marginal utility of money increases as
money with him increases.
• In case of risk-neutral individual marginal utility of money remains constant
as he has more money.

5. Risk Averter
• .Suppose the individual is currently employed on a fixed monthly salary basis of Rs. 15000.
• There is no uncertainty about the income from this present job on a the fixed salary basis
and hence no risk. Now, suppose that the individual is considering to join a new job of a
salesman on a commission basis. This new job involves risk because his income in this case
is not certain.
• This is because if he proves to be a successful salesman his income may increase to Rs. 30
thousand per month but if he does not happen to be a good salesman his income may go
down to Rs. 10 thousand per month. Suppose in this new job there is 50-50, chance of
either earning Rs. 30 thousands or Rs. 10 thousands (that is, each has a probability of 0.5).
When there is uncertainty, the individual does not know the actual utility from taking a
particular action.

6. • It will be seen from the utility function curve OU in Fig. 17.3 that the utility
of money income of Rs. 15,000 with certainty is 55.
• Further, in case of new risky job if he is proved to be a successful salesman
and his income increases to Rs. 30 thousands, his utility from Rs. 30
thousands is 75, and if he fails as a good salesman, his income falls to Rs 10
thousands which yields him utility of Rs. 45. (Note that in the new risky job,
the expected income is 20,000 which is given by E(X) = 0.5 x 10,000 + 0.5 x
30,000 = Rs. 20,000).

7. • Given that the probability of success or failure as a salesman is 0.5, the expected utility of the
new job is given by,
• E (U) = 0.5 U (10,000) + 0.5 U (30,000)
• = 0.5 x 45 + 0.5 x 75
• = 22.5 + 37.5
• = 60.0
• Thus with the present job with a fixed salary of Rs. 15,000 with no uncertainty is 55 whereas the
expected utility of the new job or salesman on commission basis is 60. Though the individuals is
risk-averse as revealed by the nature of his utility function of money income, but since the
expected utility of the risky job is greater than the utility of the present job with a certain income
he will choose the risky job

9. Risk Lover
• Risk Lover On the other hand, a person is risk-preferred or risk-loving who
prefers a risky outcome with the same expected income as a certain income.
• In case of a risk-loving individual, marginal utility of income to the
individual increases as his money income increases as shown by the convex
total utility function curve OU in Fig. 17.4.

11. • Suppose this risk-loving individual has a present job with a certain income of Rs. 20 thousands. It will be
seen from Fig. 17.4 that the utility of Rs. 20 thousands is 43 units to this individual. Now, if he is offered a
risky job with his income of Rs. 30 thousands if he happens to be highly efficient and Rs. 10 thousands if he
happens to be not so efficient in the new job with the equal probability of 0.5 in these two jobs, then the
expected utility from the new job is given by
• E (U) = 0.5 U(10,000) + 0.5 U (30,000)
• It will be seen from Fig. 17.4 that the utility of Rs. 10 thousands to this individual is Rs. 20 while utility of
Rs. 30 thousands to him is 83. Therefore,
• E (U) = 0.5 (20) + 0.5 (83)
• = 10 + 41.5
• = 51.5

12. • Since the expected utility from the new risky job is 51.5 which is greater than
the utility of 43 from the present job with a certain income of Rs. 20
thousands, the risk-loving individual will prefer the new risky job even
though the expected income in the new risky job is also Rs. 20,000 as (0.5 x
10,000) + 0.5 (30,000) = Rs. 20,000).

13. Risk-Neutral:
• A person is called risk neutral, if he is indifferent between a certain given
income and an uncertain income with the same expected value. An individual
will be risk neutral if his marginal utility of money income remains constant
with the increase in his money. The total utility function of a risk neutral
person is shown in Fig. 17.5. It will be seen from this figure that utility of a
certain income of Rs. 20 thousands is 80. Now, in a risky job when income
increases to Rs. 30 thousands if he proves to be a successful salesman, the
utility of Rs. 30 thousands is 120 units.

15. • On the other hand, if in a new risky job, he proves to be a bad salesman, his income goes down to Rs. 10,000
whose utility to the individual is 40 units. We assume that there is equal probability of high and low income
in the new risky job. Note that expected value of income in the new job with an uncertain income is 20,000
as (0.5 x 10,000 + 0.5 (30,000) = 20,000. The expected utility of the new risky job is given by E (U) = 0.5 U
(10,000) + 0.5 U (30,000).
• = 0.5 (40) + 0.5 (120)
• = 20 + 60
• = 80
• It is seen from above that in case of risk-neutral person expected utility of an uncertain income with the
same expected value (Rs. 20,000 in the present case), is equal to utility of an assured or a certain income.
That is, risk-neutral person is indifferent between them.
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