Suppose that a risk-averse decision maker faces a choice of...

Name: Problem 5, Chapter 15: Microeconomics
Uploaded: 2020-06-10T06:22:49-08:00
Duration: 44 s
Channel: Ankit Gupta
Description: Suppose that a risk-averse decision maker faces a choice of two lotteries, 1 and 2. The lotteries have the same expected value, but Lottery 1 has a higher variance than Lottery 2. What lottery would a risk-averse decision maker prefer?

Suppose that a risk-averse decision maker faces a choice of two lotteries, 1 and 2. The lotteries have the same expected value, but Lottery 1 has a higher variance than Lottery 2. What lottery would a risk-averse decision maker prefer?

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Key Concepts

Risk Aversion

This concept refers to the tendency of decision makers to prefer more certain outcomes over uncertain ones, even when the expected value is the same. A risk-averse individual would favor a lottery with less variability in outcomes because it poses lower risk, aligning with a preference for stability over potentially higher but uncertain payoffs.

Variance

Variance measures the spread or dispersion of possible outcomes around the expected value in a lottery. A higher variance indicates a wider range of possible outcomes, implying more risk. In decision-making, a lower variance is usually more attractive to a risk-averse decision maker, as it suggests a more predictable result.

Expected Utility Theory

This theory suggests that decision makers evaluate risky prospects by considering the utility derived from outcomes rather than the outcomes themselves. In cases where two lotteries have the same expected value, a risk-averse individual will choose the option with lower variability because the utility function is concave, leading to a preference for certainty and reduced exposure to potential losses.

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