Chapter 6 • Risk in investment appraisal
devoted to paying for a holiday (leaving 0P to save or spend other than on holidays),
0Q days of holiday would be obtained if the state of the world implied curve U 1 U 1 , but
the much longer period 0R days if it implied curve U 4 U 4. Different levels of utility
imply different states of the world: for example, U 4 U 4 implies that holidays are
cheaper, as compared with the U 1 U 1 position. Thus the individual would prefer the
range of possibilities portrayed by U 2 U 2 to those shown on U 1 U 1. To be on U 3 U 3 would
be even better, and on U 4 U 4 even better still. Thus while the individual is indifferent
to where he or she is on any particular curve, there is a clear preference to be on the
highest possible curve (that is, the one furthest to the top right) as this gives the max-
imum possible level of satisfaction or utility.
Figure 6.3 represents just four of an infinite number of similarly shaped curves, par-
allel to the curves shown. Note that the shape of these curves is determined by our
individual’s preferences; which curve actually applies is decreed by the state of the
world (for example, price of holidays). This example concerning the trade-off between
money spent and days away on holiday illustrates a phenomenon that seems to apply
generally to human behaviour. The more that individuals have of a particular factor
they find desirable, such as going away on holiday, the less they are willing to pay for
additional amounts of it. Thus the worth (in financial terms) of an additional day of
holiday not only varies from individual to individual, it probably also depends on
how much holiday the individual has already taken.
An alternative way in which we could represent this individual’s attitude to holi-
days is shown in Figure 6.4. Here utility itself is plotted against days of holiday. WeFigure 6.3
Various levels of
utility of going away
on holiday for a
particular individual
All points along any particular curve U 1 U 1 , U 2 U 2 , etc., would generate equal amounts of utility.
Being able to indulge in the combinations represented by a higher curve would yield greater
satisfaction. For example, spending PS to get 0Q days of holiday would be less desirable
than spending the same amount to get 0R days.