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Isoelastic utility

Isoelastic Utility

Isoelastic utility is a type of utility function in economics and finance that exhibits constant relative risk aversion (CRRA). It describes how individuals' utility, or satisfaction, changes with different levels of wealth or consumption, maintaining a consistent level of risk aversion regardless of wealth. The isoelastic utility function is often used in portfolio theory and behavioral economics to model decision-making under uncertainty.

Example

An investor with isoelastic utility preferences will make consistent risk-averse decisions, whether their wealth increases or decreases, as their relative risk aversion remains unchanged.

Key points

• A utility function that reflects constant relative risk aversion (CRRA).

• Describes how utility changes with varying levels of wealth or consumption.

• Used in portfolio theory and behavioral economics to model risk preferences.

Quick Answers to Curious Questions

What does isoelastic utility measure?

It measures how an individual’s utility changes with different levels of wealth, while maintaining constant relative risk aversion.

Why is isoelastic utility important in portfolio theory?

It helps model consistent decision-making under uncertainty, allowing investors to manage risk across different wealth levels.

How does isoelastic utility relate to risk aversion?

Isoelastic utility assumes constant relative risk aversion, meaning the individual’s risk tolerance does not change as their wealth changes.

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