(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 192

CHAPTER • 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 10 15 16 20 30 Income ($1000) (a) Utility Utility E E 18 18 C 12 C A A 10 20 30 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 probability of $10,000 and a 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