(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 194

CHAPTER 5 • Uncertainty and Consumer Behavior 169

Expected
income

Expected
income

U3
U2
U1

U3
U2
U1

Standard deviation of income
(a)

Standard deviation of income
(b)

F IGURE 5.5

RISK AVERSION AND INDIFFERENCE CURVES
Part (a) applies to a person who is highly risk averse: An increase in this individual’s standard deviation of income requires a large increase in expected income if he or she is to
remain equally well off. Part (b) applies to a person who is only slightly risk averse: An
increase in the standard deviation of income requires only a small increase in expected
income if he or she is to remain equally well off.

RISK AVERSION AND INDIFFERENCE CURVES We can also describe the

extent of a person’s risk aversion in terms of indifference curves that relate
expected income to the variability of income, where the latter is measured by
the standard deviation. Figure 5.5 shows such indifference curves for two individuals, one who is highly risk averse and another who is only slightly risk
averse. Each indifference curve shows the combinations of expected income
and standard deviation of income that give the individual the same amount of
utility. Observe that all of the indifference curves are upward sloping: Because
risk is undesirable, the greater the amount of risk, the greater the expected
income needed to make the individual equally well off.
Figure 5.5 (a) describes an individual who is highly risk averse. Observe that
in order to leave this person equally well off, an increase in the standard deviation of income requires a large increase in expected income. Figure 5.5 (b) applies
to a slightly risk-averse person. In this case, a large increase in the standard
deviation of income requires only a small increase in expected income.

In §3.1, we define an
indifference curve as all
market baskets that generate
the same level of satisfaction
for a consumer.

EX AMPLE 5. 2 BUSINESS EXECUTIVES AND THE CHOICE OF RISK
Are business executives more risk loving than most
people? When they are presented with alternative
strategies, some risky, some safe, which do they
choose? In one study, 464 executives were asked

7

to respond to a questionnaire describing risky situations that an individual might face as vice president
of a hypothetical company.7 Respondents were presented with four risky events, each of which had a

This example is based on Kenneth R. MacCrimmon and Donald A. Wehrung, “The Risk In-Basket,”
Journal of Business 57 (1984): 367–87.