Pg 11 of notes- Benefits to the insured There is a line in the 1st paragraph- "For this reason, a utility function gives less weight to very good outcomes than the weight given to very good outcomes by using expected values." I am not able to understand this clearly. What does it actually means?
Hi, All the Core Reading is trying to convey is that utility increases less than proportionately with wealth. This is due to the diminishing marginal utility of wealth, which means that each extra dollar of wealth provides us with less additional utility, as a consequence of which the utility function is concave. For example, suppose we have a log utility function. Then with a wealth of $10,000, our utility is U(10,000) = 9.21. Whereas if our wealth doubled to $20,000, our utility would increase to U(20,000) = 9.90, ie by just 7.5%. So this is what is meant by the Core Reading, when it says that: " ... a utility function gives less weight to very good outcomes than the weight given to very good outcomes by using expected values."
