(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 193

168 PART • Producers, Consumers, and Competitive Markets Utility G 20 18 E C 14 F Risk Premium A 10 10 16 20 Income ($1000) 30 40 F IGURE 5.4 RISK PREMIUM The risk premium, CF, measures the amount of income that an individual would give up to leave her indifferent between a risky choice and a certain one Here, the risk premium is $4000 because a certain income of $16,000 (at point C) gives her the same expected utility (14) as the uncertain income (a probability of being at point A and a probability of being at point E) that has an expected value of $20,000 line AE (thus representing an average of $10,000 and $30,000) But the utility level of 14 can also be achieved if the woman has a certain income of $16,000, as shown by dropping a vertical line from point C Thus, the risk premium of $4000, given by line segment CF, is the amount of expected income ($20,000 minus $16,000) that she would give up in order to remain indifferent between the risky job and a hypothetical job that would pay her a certain income of $16,000 RISK AVERSION AND INCOME The extent of an individual’s risk aversion depends on the nature of the risk and on the person’s income Other things being equal, risk-averse people prefer a smaller variability of outcomes We saw that when there are two outcomes—an income of $10,000 and an income of $30,000—the risk premium is $4000 Now consider a second risky job, also illustrated in Figure 5.4 With this job, there is a probability of receiving an income of $40,000, with a utility level of 20, and a probability of getting an income of $0, with a utility level of The expected income is again $20,000, but the expected utility is only 10: Expected utility = 5u($0) + 5u($40,000) = + 5(20) = 10 Compared to a hypothetical job that pays $20,000 with certainty, the person holding this risky job gets fewer units of expected utility: 10 rather than 16 units At the same time, however, this person could also get 10 units of utility from a job that pays $10,000 with certainty Thus the risk premium in this case is $10,000, because this person would be willing to give up $10,000 of her $20,000 expected income to avoid bearing the risk of an uncertain income The greater the variability of income, the more the person would be willing to pay to avoid the risky situation