Expected Utility and Risk Aversion

This reading describes how people’s aversion to risk affects the decisions they make about investment. Basically, the concepts used to do this analysis emerge naturally when people have expected utility preferences, but not otherwise. So, it illustrates one important way that expected utility is applied. This analysis also makes it possible to illustrate how to do comparative statics. Comparative statics typically involve calculations designed to show the direction in which changes in the environment move peoples’ optimal decisions. Convincing comparative static results are ones that hold even if you only impose weak restrictions on preferences. So, for instance, to explain how an increase in price affects a buyer’s demand when he or she has Cobb-Douglas preferences is not very convincing because Cobb Douglas preferences are a very special case. In fact, as we have already shown, an (uncompensated) increase in price will only reduce demand under very special conditions. That is why the method for doing comparative statics tend to be a little more sophisticated, and the questions asked tend not to be the most obvious ones.