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Expected Utility, Relative Risk Aversion

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An expected utility maximizing individual has utility of eno-of-period wealth given by

u(W)= W^(1-y)-1, if y is not equal to 1
ln(W), if y=1

1. Show that this individual has constant relative risk aversion and decreasing absolute risk aversion.

2. Consider the special case where y=2. Suppose that this individual is endowed with an initial wealth, Wo but his end of period wealth is subject to random income shock given as follows

\$y, with probably p
\$0, with probability 1-p

where 0<p<1

He can purchase insurance at a cost of \$c to remove the risk of receiving no income. At what level of initial wealth will he be indifferent between taking on the risk of getting no income and buying the insurance that removes the risk?

Solution Summary

Expected Utility and Relative Risk Aversion are assessed.

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An expected utility maximizing individual has utility of end-of-period wealth given by

u(W)= W^(1-y)-1, if y is not equal to 1
ln(W), if y=1
1. Show that this individual has constant relative risk aversion and decreasing absolute risk aversion.
u'(W)=(1-y)*W^(1-y-1)= (1-y)*W^(-y) if y is not equal to 1
=W^-1 if y=1
u"(W)=(1-y)*(-y)*W^(-y-1) if y is not equal to 1
=-W^-2 if y=1
Coefficient of Relative Risk Aversion = -W*u"(W)/u'(W)
When y is not equal to 1 we ...

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