Question

Uncertainty and initial wealth: a. Explain why it may be important to consider an individual’s initial wealth when analyzing how that person will react to uncertainty (Hint: think about expected utility). b. Under what circumstances will initial wealth be irrelevant to a person’s choice when faced with uncertainty?

Answer 1

Ans) a. Expected Utility refers to the Utility of an individual or an entity over a future period of time, given unknownable  circumstances.In order to understand more we can take an example as an individual calculates the probabilities  of expected items and weigh them against the expected Utility before taking a decision. To a great extent the expected utility depends on the marginal utilty hence the expected utility of gain or reward decreases when a person is rich as compared to a poor person. We can take an example by taking a wealthy person 'A' and a poor person 'B'. A is wealthy and B is innovative both of them enters into partnership , the terms of the partnership can only be as A is wealthy he can invest the money say 1 million doller into the innovative idea of B.

B knows that if the innovation would become successfull they will earn 5 million each will share equally and if it would not then only 0.5  million would be the loss. Since there is uncertainity involved in it hence the decision to deal with the uncertainity  will depends on the expected utility , for the poor person B , he would opt the scenario

he can earn 2.5 million ,if he would enter into partnership and has diminishing marginal utility for an amount greater than 2.5 million on the other hand it is much profitable for him to go from 0 to 2.5 million than from 2.5 million to 5 million. On the other hand A a wealthy person would not partner with B if he has the idea prior to B , as he hopes to earn 5 million alone.

Ans b) There can be many circumstances where initial  wealth of a person becomes irrelevant when making a choice during uncertainity as clear from the given example if there is a risk seeking individuall A he has the ability to take risks and starts off a risky sort of business with high uncertainity , than he is not concerned about his initial wealth as he is ready to take risk and start a business which will give hime huge rewards and ready to take loss. Hence his expected utility from this business is high