Relation Between Money and Its Utility

At the heart of risk aversion is the notion of diminishing marginal utility for money. If someone with no money receives $5,000, it can satisfy his or her most immediate needs. If such a person then receives a second $5,000, it will obviously be useful, but the second $5,000 is not quite so necessary as the first $5,000. Thus, the value, or utility, of the second, or marginal, $5,000 is less than the utility of the first $5,000, and so on. Diminishing marginal utility of money implies that the marginal utility of money diminishes for additional increments of money. Figure 14.4 graphs the relation between money and its utility, or value. In the figure, utility is measured in units of value or satisfaction, an index that is unique to each individual.

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