The certainty equivalent of a gamble or lottery is the sum of money for which, in a choice between the money and the gamble, the decision maker is indifferent between the two. Certainty equivalents are used to determine decision makers' attitudes toward risk, which can then be reflected in the shape of their utility functions. Certainty equivalents can also be used to order a set of alternatives. Classic examples of operationalizations of certainty equivalents used in the literature are minimum selling price, maximum buying price, and cash equivalent. Buying and selling prices may be theoretically different though, due to income effects.
By definition, the utility of the certainty equivalent must be equal to the expected utility of the gamble. With this in mind, the relationship between the certainty equivalent (CE) and the expected value (EV) of a gamble can reveal the decision maker's attitude toward risk. If CE < EV, then the individual is said to exhibit a risk-averse attitude. In...
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