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Risk Aversion and the State Preference - Assignment Example

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The purpose of this paper “Risk Aversion and the State Preference” is to compare the State Preference and Machina triangle diagrams, explain an Edgeworth Box diagram, and discuss the factors that determine the efficient allocation of risk. Risk aversion refers to the investor preferring less risk to more risk…
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Risk Aversion and the State Preference
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Download file to see previous pages An individual is a risk-averse if for any probability distribution the expected value of the distribution is preferred to the distribution itself. An individual who prefers a certain income rather than an uncertain one is said to be risk-averse. “In contrast, a risk-neutral person is one who is indifferent to all alternatives with the same expected value” (Katz and Rosen 1998, p.168). For the consumer, uncertainty in the economic market could relate to a combination of or any one of the following factors: income, product price, product quality, and product availability, besides future income, interest rates and inflation rates (McKenna 1986). According to Eeckhoudt and Gollier (1995), the inverse relationship between marginal utility and wealth in the context of expected utility, explains why the largest loss should be covered first through insurance. The State Preference and Machina Triangle Diagrams
The State Preference and the Machina Triangle diagrams can be compared and contrasted, as indifference maps for risk-averse expected utility maximizers. The expected utility model as an approach to the theory of individual behavior towards risk is distinctive due to the simplicity of its axioms, employing utility function and mathematical expectation, its utility functions such as risk aversion by concavity characterizing its various types of behavior (Machina 1982). The expected utility hypothesis of behaviour towards risk is essentially that the individual decision-maker possesses a von Neumann-Morgenstern utility function U(.) or von Neumann-Morgenstern utility index U1 “defined over some set of outcomes, and when faced with alternative risky prospects over these outcomes will choose that prospect that maximizes the expected value of U(.) or U1 (Machina 1988)
The State Preference approach can be applied naturally to Insurance, since it is a clear “state-contingent” contract, that is, it pays an indemnity if a loss occurs. ...Download file to see next pagesRead More
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