(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 192
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CHAPTER 5 • Uncertainty and Consumer Behavior 167
of the risk premium depends on the risky alternatives that the person faces.
To determine the risk premium, we have reproduced the utility function of
Figure 5.3 (a) in Figure 5.4 and extended it to an income of $40,000. Recall that
an expected utility of 14 is achieved by a woman who is going to take a risky
job with an expected income of $20,000. This outcome is shown graphically by
drawing a horizontal line to the vertical axis from point F, which bisects straight
Utility
E
18
D
16
C
14
13.5
B
F
A
10
0
10
15 16
20
30
Income ($1000)
(a)
Utility
Utility
E
E
18
18
C
12
C
8
6
A
A
3
0
10
20
30
0
10
20
(b)
30
Income ($1000)
Income ($1000)
(c)
F IGURE 5.3
RISK AVERSE, RISK LOVING, AND RISK NEUTRAL
People differ in their preferences toward risk. In (a), a consumer’s marginal utility diminishes as income increases.
The consumer is risk averse because she would prefer a certain income of $20,000 (with a utility of 16) to a
gamble with a .5 probability of $10,000 and a .5 probability of $30,000 (and expected utility of 14). In (b), the
consumer is risk loving: She would prefer the same gamble (with expected utility of 10.5) to the certain income
(with a utility of 8). Finally, the consumer in (c) is risk neutral and indifferent between certain and uncertain events
with the same expected income.
