Attitudeoftheeconomicagenttowardsrisk.

Meansofmeasurement
Colomeischi T.
Abstract This paper emphasizes an analysis concerning attitude towards risk of the economic agents in uncertainty
conditions. The paper begins with a general presentation of various approachesover concepts ofcertainty, uncertainty
andrisk.Lateron,ananalysisabouttheeconomicagentsattitudetowardsriskiscarriedout,thusdefiningtheaversion,
neutrality and predilection towards risk of the individuals by means of the utility functions. The main characteristics
thatmeasureattitudetowardsriskoftheeconomicagentsareexplainedinthethirdparagraph:thecertaintyequivalent,
theriskpremium(prize),thecoefficientofabsoluteriskaversion,thecoefficientofrelativeriskaversionandtheArrow
Prattriskpremium.

Keywords: uncertainty,risk,utilityfunction,lottery,riskaversion

1. GENERAL CONSIDERATIONS CON
CERNING THE CERTAINTY, UNCER
TAINTYANDTHERISK

The decisions that an organization has been tak

ing over time base upon the information of the past and
present, as well as the futures precognitions. Of course,
the precognitions are approximate, so that the anticipa
tions of deciders have proven levels of uncertainty. The
theoretical approaches make distinctions between two
statesofanticipations:certaintyanduncertainty.
Certainty is used in order to describe situations
whenanticipationshaveonevalue.Forinstance,incondi
tions of certainty, the anticipations of a manufacturer as
regards the results of his decisions on choosing a combi
nation of the production factors are singular. The manu
factureraccuratelyanticipatestheproductionthatwillbe
achieved, which value the encashment will have and
which costs and benefits will result.Analogically, the de
cisions of a consumer are associated in certainty condi
tionstosomesingularanticipation,asregardstheavaila
bleprofitandtheutilitycorrespondingtovariousgroups
ofgoodsandservices.Thecertaintytermisusedtositua
tions where anticipations do not have one single value,
butareincludedwithinashortinterval.
Thecertaintyisnotpassingthetestofreality,and
changing this view and introducing the concepts of risk
and uncertainty are thus imposed. Interpretations of
these two concepts have been very different over time,
and various approaches have lead towards the following
definitions:
- an economic phenomenon will be developed in
risk conditions if its result is not surely known,
butpossibilitiesofaccomplishmentcanbeestab
lishedforvarioussituationsorresultsoccurred;
- One might say that an economic phenomenon
takesplaceinconditionsofuncertaintyifspecif
ic probabilities cannot be associated to various
results.
Bernoulli (1738) was the first author that carried out an
approach about the marginal utility concept, in situation
of risk conditions, being followed by Menger (1871),
Fisher (1906) and Edgeworth (1908), which analyzed the
influencesofriskanduncertaintyovertheeconomicphe
nomena.Althoughthefirstauthorthatmadeadistinction
between risk and uncertainty was Knight (1921) in his
paper entitled Risk, Uncertainty and Profit. The basis of
economical theory in conditions of risk and uncertainty
areassignedtovonNeumannandMorgenstern(1944)in
the paper entitled Theory of Games and Economic Beha
vior.
Friedman and Savage (1948) introduced and
studied the risk aversion term, being followed by Marko
witz (1952), Pratt (1964), Arrow (1965) and Ross (1981).
Measuring the risk aversion in multiple conditions has
been studied by Yaari (1969), as well as Kihlstrom and
Mirman (1974). The attention dedicated to risk
represented the main topic of papers written by Roth
schild and Stiglitz (1970 and 1971), and afterwards by
DiamondandStiglitz(1974).
The concept of expected utility has been for the
first time introduced by Savage (1954), his results being
developed from the subjective point of view introduced
byAnscombeandAumann(1963).
Another approaching trend of uncertainty has
been that of preference states, introduced by Arrow (1953)
and continued by Debreu (1959) and Hirshleifer (1958
and1966).
Theeconomicagentbehaviorrelatedtothemod
ifications of income (occurred in uncertainty conditions)
was analyzed by Menezes, Geiss and Tressler (1980),
where they defined the concept of downside type aver

- Colomeischi T. is with University of Suceava, 13 University Str., Suceava,
Romania
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sion, their theory being continued afterwards by Modica
andScarsini(2005).
Quite recently, using the balanced estimated utility
was carried out by Allais (1979), Chew and Mac Crim
mon (1979), Quiggin (1982), Fishburn (1983) and Yaari
(1987),andthenusingthenonlinearutilitywascarriedout
by Machina (1982) or of the nonadditive estimated utility
wascarriedoutbySchmeidler(1989).
Theanalysisofriskaversionbymeansofcaution
index was approached by Kimball (1990) and then by
KeenanandSnow(2002).
Many approaches of the risk and uncertainty
issue in economy have lead to the crystallization of three
greattheories:thetheoryofvonNeumannandMorgens
tern as regards the estimated utility with objective probabili
tiesthatdefineinthebestwaytheconceptofrisk,Arrows
theory as concerns the preferred states of the nature that
practically synthesize the concept of uncertainty, as well
asthetheoryoftheestimatedutilitywithsubjectiveprobabili
tiesofSavage,theorythatsuggestsboththeriskconcept,
by probabilities appearance, as well as the uncertainty
one,duetothesubjectivefeatureoftheseprobabilities.

2. THE ATTITUDE OF THE ECONOMIC

AGENTTOWARDSRISK

The preferences of individuals related to various

situations of random character underlie the estimated
theoryofvonNeumannandMorgenstern.Theserandom
situationscarrythenameoflotteries.Inthisway,wewill
define the lottery as being a discrete random variable, of
a distribution under the form
1 2
1 2
...
...
n
n
x x x
p p p
| |
|
\ .
where {x1, x2, , xn} is the set of
values (results) that a random variable X can take, and
pi=P(X=xi), 1, i n = represent their accomplishment prob
abilities. In order to make a connection to the economic
field,wewillconsiderthatx1,x2,,xn representtheesti
matedearningsofanagent.

2.1 Comparisonbetweenlotteries
The issue of comparing the lotteries is obviously
occurring. This comparison can be carried out in accor
dancetotwocriteria:
a. The criterion of the mathematical earnings antic
ipated value indicates the choosing of lottery with the
highest anticipated value. Thus, if
1 2
1 2
...
:
...
n
n
x x x
X
p p p
| |
|
\ .
and
1 2
1 2
...
:
...
n
n
x x x
X
p p p
' ' '
| |
'
|
' ' '
\ .

aretwolotteries,theXlotterywillbechosenif:
( ) ( ) ( ) ( )
1 1
n n
i i i i
i i
E X E X p x p x
= =
' ' ' > >

.
b. The criterion of the expected utility value, according
towhomthelotterywiththehighestmathematicalantic
ipatedvaluewillbechosen.
If : U signifies the utility function of von Neu
mann Morgenstern type (signifying that is strictly in
creasing, strictly concave and of C
2
class), the X lottery
willbechosenif:
( ) ( )
1 1
n n
i i i i
i i
p U x p U x
= =
' ' > ( (


.

2.2 The aversion, neutrality and predilection to
wardsrisk
Regardingtheattitudeoftheeconomicagenttowards
risk,thiscaninclude:
a. Risk aversion. One might say that an individual has
riskaversion(andthatwillbecalledriskphobic)ifheisnot
willing to accept a null lottery (meaning that the mathe
matical anticipated value of the gain is zero). In other
words, the utility of the wealth already held is higher
than the utility of the probable wealth that might be
achievedinthesituationoflotteryacceptance.
If one analyzes the twodimensional case, an
economical agent has risk aversion when the utility U
functionisstrictlyconcave:
( ) ( ) ( )
1 1 2 2 1 2
1 2
U p x p x p U x p U x + > +
.
The utility function for an individual with risk
aversion can be represented under the form from Figure
1.
Asexamples ofutilityfunctionsdedicatedtothe
economic agents with risk aversion, one might mention:
the radical function ( ) U x x = or the logarithmical func
tion ( ) ln U x x = .
Risk aversion is practically that determining in
dividuals to ensure against the potential damages, they
agreeingtopayinsurancebonustosomeintervals,witha
lower value than the probable value of damages in the
absenceoftheinsurance.

Figure1.Formoftheutilityfunctionforaneconomic
agentwithriskaversion
X x
2
x
1
E(X)
E(U(X))
U(x
1
)
U(x
2
)
U(X)
U(E(X))
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b. Neutrality(indifference)towardsrisk.Anindividual
willbeconsideredasneutraltowardsriskifhehasnopre
ference as regards his accept or denial as concerns a null
lottery.
As regards the twodimensional case, this signi
fiesthatthefunctionUislinear,meaning:
( ) ( ) ( )
1 1 2 2 1 1 2 2
U p x p x p U x p U x + = + .
The graphic of a utility function for a neutral
agenttowardsriskisundertheformofastraightline,as
canbeseeninFigure2:

Figure2.Formoftheutilityfunctionforaneconomic
agentregardlesstherisk

Giving examples, the utility functions of the risk

neutral agents are linear functions, under the form of
( ) , 0, U x ax b a b = + > e .
c. Predilection(tolerance)torisk.Anagentisrisktender
(beingalsocalledriskfond)ifheiswillingtoacceptanull
lottery.
The utility function associated to an individual
withriskaversioncanberepresentedunderthefollowing
form:

Figure3.Formoftheutilityfunctionforanindividual
ofrisktendency

In the twodimensional case, U signifies a strictly convex

function:
( ) ( ) ( )
1 1 2 2 1 1 2 2
U p x p x p U x p U x + < + .
As examples of such utility functions one might
enumerate the exponential function ( )
x
U x e = or the
seconddegreefunction ( )
2
U x ax bx c = + + .

3. PARAMETERS THAT MEASURE ATTI

TUDETOWARDSRISK

Thethreeattitudestowardsriskofanindividual
can be defined and especially measured by means of the
followingparameters:

1) The certainty equivalent signifies the earnings

that are brought by a satisfaction equal to the medium
satisfaction of the lottery. Therefore, the certainty equiva
lent,denotedbyEc,willchecktherelationship:
( ) ( ) ( )
c
U E E U X = .
In this situation, the agent will prove risk aversion if
( ) ( ) ( )
c
U E E U X < , and will be risk neutral if
( ) ( ) ( )
c
U E E U X = ,andwillproveriskpredilectionif
( ) ( ) ( )
c
U E E U X > .
Takingintoconsiderationanindividualwithrisk
aversion and an individual with risk predilection, the
difference between the utility expected by the two indi
viduals is justified by the fact that the riskphobic indi
vidual will perceive the utility from the view of the pri
mary necessities (food, clothing), while the risktender
willperceiveitfromtheviewofthesecondarynecessities
(comfort,spendingthefreetime).

2) Another parameter of measuring the attitude

towards risk is represented by the risk premium (prize).
This is denoted by
X
and complies with the relation
ship:
( ) ( ) ( ) ( )
X
U E X E U X = .
Therefore, the risk premium signifies the reward that an
agentagreestopayinordertoensuretheearningsequal
to that specific to the lottery. Introducing in the previous
relationship the certainty equivalent and taking into ac
countthatthefunctionUisstrictlyincreasing,onemight
noticetheresult:
( ) ( ) ( ) ( ) ( )
( )
X c X c c X
X c
U E X U E E X E E E X
E X E

= = + =
=
.
Related to the attitude of the individual towards
risk,theriskpremiumwillbenegative,positiveornull.
Iftheagenthasriskaversion,hisutilityfunction
willbeincreasingandconcave,meaning:
( ) ( ) ( ) ( )
U E X E U X > .
Though, ( ) ( ) ( )
c
U E E U X = and according to the
abovementionedrelationship,wewillhave:
( ) ( ) ( )
c
U E X U E > .
Knowingthatthefunctionofutilityisincreasing,wewill
deductthat:
( ) 0
c X
E X E > > .
In this way, the individual with risk aversion has a positive
riskpremium,andheiswillingtosellthelotteryatalower
X x
2
x
1
E(X)
E(U(X))
U(x
1
)
U(x
2
)
U(X)
U(E(X)) =
X x
2
x
1
E(X)
E(U(X))
U(x
1
)
U(x
2
)
U(X)
U(E(X))
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price (he is known as reducing the significance of the
riskinglotteries).
As concerns an agent with risk predilection, we
willhaveafunctionofincreasingandconvexutility,thus
resulting:
( ) ( ) ( ) ( )
U E X E U X < .
Knowing that ( ) ( ) ( )
c
U E E U X = and according to
theabovementionedrelationship,wewillhave:
( ) ( ) ( )
c
U E X U E < .
KnowingthattheutilityfunctionUisincreasing,wewill
achieve:
( ) 0
c X
E X E < < .
One might say that a risk tender agent has a negative risk
premium, since he supplementary appreciates the risk of
lottery,thepriceatwhichheiswillingtobuybeinggreat
erthattheestimatedvalueofit.
For an individual being indifferent to risk, the
utilityfunctionislinearand:
( ) ( ) ( ) ( )
U E X E U X = .
Though, ( ) ( ) ( )
c
U E E U X = according to the above
mentionedrelationship,wewillhave:
( ) ( ) ( )
c
U E X U E = .
KnowingthattheutilityfunctionUisincreasing,wewill
deductthat
( ) 0
c X
E X E = = .
Therefore,anindividualofriskneutralfeaturehasanullrisk
premium, meaning that theprice at which he is willing to
buythelotteryisequaltoitsestimatedvalue.

3) The coefficient of absolute risk aversion for a

certain level of the earnings, x , will be defined by the
relationship:

( )
( )
( )
a
U x
r x
U x
''
=
'
.

4) The coefficient of relative risk aversion, de

notedby ( )
r
r x isdefinedby:
( )
( )
( )
r
U x
r x x
U x
''
=
'
.

It represents the elasticity of the marginal utility as re

latedtothewealth.

5) TheriskpremiumofArrowPratttype
Forarandomvariableundertheformof X x e = + and
respecting some hypothesis (of average x , variance
2
o
and moments of superior order negligible as related to
thedispersion)andafunctionofutilityUstrictlyincreas
ing, strictly concave and of class C
2
, Arrow and Pratt
achieved, by Taylor series, the expression of the absolute
aversiontorisk,dependingupontheriskpremiumunder
theform:
( )
( )
( ) ( )
2
2
2 ,
1
,
2
X
a X a
x e
r x x e r x

o
o
= =

,
Here, ( ) ,
X
x e signifies the risk premium of the initial
wealth x .Inthisway,onehasreachedtoalocalparame
teroftheriskaversion,foralowleveloftherisk.

4.THEARROWPRATTTHEOREM

One might notice three ways of comparing the

risk aversion from the above mentioned, concerning the
twoeconomicagentsunderanalysis.Firstly,theindicesof
the risk aversion are determined upon basis of the utility
functionU,theybeinginvarianttoanylinearandpositive
transformation (as related to the
form ( ) ( ) U x a U x b + , with a>0). Afterwards,
thereisanintrinsicconnectionbetweenthesecoefficients
and preferences of the economic agent, expressed as re
gards the risk premium. Finally, the risk aversion can be
defined as related to the concavity specific to the utility
function.
The three approaches above mentioned are syn
thesizedbytheArrowPratttheorem(1964).IfU1andU2
aretwofunctionsofutilitystrictlyincreasing,strictlycon
cave and of class C
2
, in this way, the following affirma
tionsareequivalent:
a) ( ) ( )
1 2
, 0
a a
r x r x x > > ;
b) ( ) ( )
1 2
, , , 0, x e x e x e > > verylow;
c) There is a concave function : | , so
that
1 2
U U | = .
The third affirmation of the theorem can be thus
explained: the function U1is more concave than the
function U2 or the first individual has a risk aversion
higherthanthesecondone.

5.CONCLUSION
Attitude towards risk of an economic agent is
emphasized by the form of his utility function. The eco
nomicagentwillproveriskaversionwhenhisfunctionof
utilityisstrictlyconcave.Aneconomicagentwillbeindif
ferent towards risk if his utility function is linear. If the
utilityfunctionisstrictlyconvex,theagentwillhaveten
dencytowardsrisk.
By means of parameters that measure attitude
towards risk, three ways of comparing the risk aversion
those two economic agents have can be distinguished,
beingsynthesizedbytheArrowPratttheorem.
Firstly, the coefficients of the risk aversion are
determined upon basis of the utility function U, they be
ing invariant to any linear and positive transformation.
Afterwards, an intrinsic connection exists between these
coefficients and the preferences of the economic agent,
expressed by the risk premium. Finally, the risk aversion
canbedefinedasrelatedtotheutilityconcavityfunction.

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Tudor Colomeischi Chair Lector of Accounting, Finance

and Informatics Department, Economic Study and Public
Administration Faculty, Stefan cel Mare University from Su
ceava. Authors 3 papers published in Journal rated by ISI
Thompson and 15 scientifically papers published in the
country and abroad at the International Symposiums or
Conferences. Shes experienced in research contracts, shes
partoftheresearchteamin2contractedprojects.

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