ptimally increasing expected net gains does not take into consideration risk attitudes or an individual’s attitude to carrying the risk of uncertainty, it is risk neutral. On the other hand, the individual’s attitude to risk bearing is taken into account if expected utility rather than expected gain is to be maximised. Risk premium, equity premium or market premium refers to the additional allowance for risk which results in high rates of interest in the private sector. “The market risk premium is the expected rate of return in the aggregate stock market in excess of the risk-free interest rate” (Fernandez 2002, p.201).
Thesis Statement: The purpose of this paper 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.
An individual is 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 the Machina Triangle diagrams can be compared and contrasted, as indifference maps for risk averse expected utility maximisers. The expected utility model as an approach to the theory of individual behaviour towards risk is distinctive due to the