Risk aversion
For example, a risk-averse investor might choose to put their money into a bank account with a low but guaranteed interest rate, rather than into a stock that may have high expected returns, but also involves a chance of losing value.
The expected payoff for both scenarios is $50, meaning that an individual who was insensitive to risk would not care whether they took the guaranteed payment or the gamble.
The smallest guaranteed dollar amount that an individual would be indifferent to compared to an uncertain gain of a specific average predicted value is called the certainty equivalent, which is also used as a measure of risk aversion.
This risk premium means that the person would be willing to sacrifice as much as $10 in expected value in order to achieve perfect certainty about how much money will be received.
In the case of a wealthier individual, the risk of losing $100 would be less significant, and for such small amounts his utility function would be likely to be almost linear.
[8] Analogously, IARA can be derived with the opposite directions of inequalities, which permits but does not require a negatively skewed utility function (
Thus economists avoid using utility functions such as the quadratic, which exhibit increasing absolute risk aversion, because they have an unrealistic behavioral implication.
An extension of the expected utility function, the von Neumann-Morgenstern model includes risk aversion axiomatically rather than as an additional variable.
[14] John von Neumann and Oskar Morgenstern first developed the model in their book Theory of Games and Economic Behaviour.
[15] In defining expected utility in this sense, the pair developed a function based on preference relations.
As such, if an individual’s preferences satisfy four key axioms, then a utility function based on how they weigh different outcomes can be deduced.
Using expected utility theory's approach to risk aversion to analyze small stakes decisions has come under criticism.
[17] Rabin criticizes this implication of expected utility theory on grounds of implausibility—individuals who are risk averse for small gambles due to diminishing marginal utility would exhibit extreme forms of risk aversion in risky decisions under larger stakes.
This effect was first presented by Kahneman and Tversky as a part of the prospect theory, in the behavioral economics domain.
This pattern is an indication of risk-seeking behavior in negative prospects and eliminates other explanations for the certainty effect such as aversion for uncertainty or variability.
Subsequently, an extensive investigation revealed its possible limitations, suggesting that the effect is most prevalent when either small or large amounts and extreme probabilities are involved.
[21] Based on both the von Neumann-Morgenstern and Nash Game Theory model, a risk-averse person will happily receive a smaller commodity share of the bargain.
[23] Intuitively, a risk-averse person will hence settle for a smaller share of the bargain as opposed to a risk-neutral or risk-seeking individual.
In the real world, many government agencies, e.g. Health and Safety Executive, are fundamentally risk-averse in their mandate.
This often means that they demand (with the power of legal enforcement) that risks be minimized, even at the cost of losing the utility of the risky activity.
The public understanding of risk, which influences political decisions, is an area which has recently been recognised as deserving focus.
In 2007 Cambridge University initiated the Winton Professorship of the Public Understanding of Risk, a role described as outreach rather than traditional academic research by the holder, David Spiegelhalter.
However, these are only designed to save children from death in the case of direct falls on their heads and do not achieve their main goals.
Shiela Sage, an early years school advisor, observes "Children who are only ever kept in very safe places, are not the ones who are able to solve problems for themselves.
[32] The basis of the theory, on the connection between employment status and risk aversion, is the varying income level of individuals.
In terms of employment the greater the wealth of an individual the less risk averse they can afford to be, and they are more inclined to make the move from a secure job to an entrepreneurial venture.
Incentive effects are a factor in the behavioural approach an individual takes in deciding to move from a secure job to entrepreneurship.
Utility functions do not equate for such effects and can often screw the estimated behavioural path that an individual takes towards their employment status.
[34] The design of experiments, to determine at what increase of wealth or income would an individual change their employment status from a position of security to more risky ventures, must include flexible utility specifications with salient incentives integrated with risk preferences.
[34] The application of relevant experiments can avoid the generalisation of varying individual preferences through the use of this model and its specified utility functions.
