Economic Perspectives II

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Information As An Inducer Of Risk-Neutral Behavior

The next hypothesis of "Why Information Should Influence Productivity" looks at its title question from a different angle:

Hypothesis 2: Information that reduces risk aversion increases productivity when it leads to actions that are closer to true risk neutral levels.

Take the following example. Two investors are considering where to place their hard-earned money for future growth. Investor A is very rich, and has a lot of room to play with respect to her budget. Thus, she will tend to invest in stock that promises a high expected output, even if the risk (variance in output) is high. On the other hand, investor B is much poorer. A large loss would be considerably more disastrous for her. She will tend to place relatively more importance in the certainty of an investment, even if it comes at a price of lower average output. To her, the attractiveness of a stock with high expected payoff is lowered significantly if the stock is also very volatile.

Since investor A bases her decisions solely on the expected value of the stock, regardless of the variance, we call her a risk-neutral agent. Investor B, on the other hand, is risk-averse, for she cannot afford to ignore the risk associated with each investment opportunity.

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