Question 1

The utility function shows the relationship that exists between an individual’s utility (U) gained and his total income (Y). It depends positively on the level of income (Y) and the exponent (α). α Can either be greater/less than or equal to one. The closer the value of α is to one the more risk averse Mr D would be and the farther the value of α is from one the more risk loving he is.

In a situation where the value of α is less than one this implies that Mr D dislikes every form of uncertainty and would do anything possible to have a certain outcome. He would rather have a higher amount expected wealth than expected utility. In this situation Mr D is said to be risk averse. For example he would rather be an employed staff at a bakery and be sure to get a certain level of income on a regular basis with job security than own his own delivery firm, which would involve a lot of risk with larger pay. Being in an uncertain situation decreases the amount of utility Mr D can derive. He observes a decreasing marginal utility of income also known as disutility of uncertainty.

If the α is equal to one Mr D is indifferent and has no exact preference to whatever outcome he gets. He would not mind getting a certain amount of income which is lower or taking the gamble to get the higher income. In this case Mr D is said to be risk neutral. He does not have anything to lose or gain from being indifferent because he gets a constant marginal utility of income from his utility function.

Lastly, if α is greater than one this suggests that Mr D likes a lot of uncertainty and is prepared to bear the risks to achieve a higher outcome in the end. He would not want any form of certainty in his business and would not take up any actions to try and eliminate the uncertainty