Question

Consider three choices A, B, C. Choice A gives $30 with probability 1/2 and $70 with probability 1/2. Choice B gives $50 with certainty. Choice C gives $40 with probability 1/2 and $70 with probability 1/2.
(a) [2 points] For a risk averse individual, determine if the individual (i) prefers A over B, or
(ii) prefers B over A, or (iii) more information on the individual's risk attitude is needed to compare A,B for the individual.
(b) [4 points] Carry out the same comparison as in (a) between choices (A,C) and (B,C) for a risk averse individual.
(c) [3 points] How do the conclusions in (a)-(b) change when the individual is risk neutral instead of risk averse?

Answer 1

Risk aversion means that when an idividual is exposed to uncertainity he /she tries to minimise the risk. it related to their financial preferences and chose the option to give a sure outcome over a gamble with higher or equal expected value. so answer to part :

A- The individual who wants to averse or minimise risk will prefer option B ver A which is giving $50 with certainity. as it will give him sure return of $50 over a gamble of 30:70. with equal probability.

B- a risk averse individual will prefer C over A as it has equal probability of 40:70 as compared to 30:70 in option A. as C option is minimising the risk from certain returns and in case of option A equal higher returns are expected with equal probability as option C while on lower side risk is greater in option A.

c-In case of risk neutal person the choicem may be option A as the chances of maximising returns on higher side are as equal to lower side as (minimum returns) . while chosing between A & C he may go with option C as C option is maximising the returns and in case of option A equal higher returns are expected with equal probability as option C while on lower side risk is greater in option A. But we will need bit more information about the risk neutrality.Risk neutrality is an economic term that describes individuals' indifference between various levels of risk., as if given achoice among different investment opportunities, risk-neutral person considers the expected value of the alternative and not the associated level of risk. risk neutrak person is only indifferent to risk but may consider other things.Such mindset is often situational and can be dependent on price or other external factors.