Question

In: Economics

A risk averse individual is offered a choice between getting $400 for sure and entering a...

A risk averse individual is offered a choice between getting $400 for sure and entering a gamble that promises a gain of $1000 with probability 0.25 and a gain of $300 with probability 0.75. Given this situation, he or she will

  1. definitely take the gamble
  2. definitely not take the gamble
  3. definitely take the gamble if his or her income is high enough
  4. take an action that cannot be determined without specifying the individual’s utility function

Solutions

Expert Solution

Ans.

Correct Option is - D.

Guaratee money =$400

Expected Value of Lottery = 1000 x 0.25 + 300 x 0.75

                                          = 250 + 225 = $475

Risk Premium = $475 - $400 = $75

We see that expected return is $75 more than the sure money of $400 , This return might or might not be accepted by the person , because to know how much of a risk averse person is he ,which can be measured by the utility function of this individual.

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