Question

Explain, using a diagram, why a risk-averse individual, choosing between two prospects with the same expected value, prefers the prospect with the smaller spread in the out- comes.

Answer 1

People's preferences towards risk differs . Most people generally prefer the less risky situation and are called risk averse.These different preferences towards risk depend on whether the marginal utility of money diminishes or increases or remains constant for the individual.For the risk averse individual , the marginal utility of money diminishes as he has more money.If the utility of a riskless prospect is more than the expected utility from a risky prospect then the individual is risk averse and has diminishing marginal utility of wealth.In such case , the additional utility that is achieved by taking the risky prospect , is not very big to offset the loss in utility that is achieved from that prospect.

In the fig we measure money income on the X axis and utility on the Y axis.The OE curve shows the utility function of an individual who is risk averse.The slope of the total utility function decreases as the money income of the individual increases.Thus the utility function curve is concave.When money income increases from Rs 10 to 20 thousand ,his total utility increases 20 units and when money income increases from Rs 20 thousand to 30 thousand his total utility increases by 10 units. .