SummaryEveryone has to make decisions, but it is not always clear to us what outcomes can derive from these decisions. When this happens, we say we are making decisions in situations under risk or uncertainty. In this LP we learn about risk and uncertainty. We see how risk can be analysed by using expected utility instead of expected value, and how different kind of people will behave differently when facing risk.
It is sometimes important to know how averse to risk a certain individual is. To this effect there are a set of tools to measure risk in a quantitative way. The most common and frequently used measure of risk aversion are the Arrow-Pratt measures of absolute and relative risk-aversion. Named after John W. Pratt’s paper “Risk Aversion in the Small and in the Large”, 1964, and Kenneth Arrow’s “The Theory of Risk Aversion”, 1965, these are the measures:
Arrow-Pratt measure of absolute risk aversion:
Arrow-Pratt measure of relative risk aversion:
Where x is the payoff of a given lottery and U(x) the utility derived from that payoff.