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5 dollars. With probability 1-p, the ticket loses and pays nothing. One ticket costs 1 dollar. (a) If Bob has von Neumann-Morgenstern utility u(x) = 2³ over change in wealth z, what is the certainty equivalent for Bob of buying one ticket (as a function of p)? What is the risk premium? Solution: If Bob buys a raffle ticket, then with probability p he gains 4 dollars (5 dollars minus the price of the ticket), and with probability 1-p he loses 1 dollar. His

5 dollars. With probability 1-p, the ticket loses and pays nothing. One ticket costs 1 dollar. (a) If Bob has von Neumann-Morgenstern utility u(x) = 2³ over change in wealth z, what is the certainty equivalent for Bob of buying one ticket (as a function of p)? What is the risk premium? Solution: If Bob buys a raffle ticket, then with probability p he gains 4 dollars (5 dollars minus the price of the ticket), and with probability 1-p he loses 1 dollar. His

ENGR.ECONOMIC ANALYSIS
ENGR.ECONOMIC ANALYSIS
14th Edition
ISBN:9780190931919
Author:NEWNAN
Publisher:NEWNAN
Chapter1: Making Economics Decisions
Section: Chapter Questions
Problem 1QTC
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please  only do: if you can teach explain steps of how to solve each part b

Bob le Flambeur is offered a raffle ticket. With probability p, the raffle ticket wins, and pays 5 dollars. With probability 1-p, the ticket loses and pays nothing. One ticket costs 1 dollar. (a) If Bob has von Neumann-Morgenstern utility u(r) = ³ over change in wealth , what is the certainty equivalent for Bob of buying one ticket (as a function of p)? What is the risk premium? Solution: If Bob buys a raffle ticket, then with probability p he gains 4 dollars (5 dollars minus the price of the ticket), and with probability 1-p he loses 1 dollar. His expected utility is therefore 64p-(1-p) = 65p-1. The certainty equivalent is therefore CE(p) = 365p 1. The expected value of the lottery is 4p - (1 - p) = 5p - 1, giving a risk premium of R(p) = 5p-1-65p - 1. (b) Now suppose that, instead of the utility function above, Bob is risk-neutral. An un- scrupulous raffle saleswoman makes Bob the following offer. For 50 cents, she will tell him whether the ticket for sale will win or lose before Bob decides whether to buy it. If p = 1, will Bob accept the saleswoman's offer? Assume that there is only one ticket available for him to purchase. Solution: Bob has three options: accept the offer, reject the offer and buy a ticket, or reject the offer and not buy a ticket. Since Bob is risk-neutral, he cares only about maximizing the expected value of the lottery he chooses (i.e. we can suppose that u(x) = r). If he rejects the offer, the expected value associated with buying a ticket is 5-1= 0.25 > 0, so he prefers to buy a ticket. If he accepts the offer, then he loses 50 cents for sure, but gains 4 with probability, giving expected value 1-0.5 = 0.5> 0.25. Therefore, Bob will accept the offer.
Transcribed Image Text:Bob le Flambeur is offered a raffle ticket. With probability p, the raffle ticket wins, and pays 5 dollars. With probability 1-p, the ticket loses and pays nothing. One ticket costs 1 dollar. (a) If Bob has von Neumann-Morgenstern utility u(r) = ³ over change in wealth , what is the certainty equivalent for Bob of buying one ticket (as a function of p)? What is the risk premium? Solution: If Bob buys a raffle ticket, then with probability p he gains 4 dollars (5 dollars minus the price of the ticket), and with probability 1-p he loses 1 dollar. His expected utility is therefore 64p-(1-p) = 65p-1. The certainty equivalent is therefore CE(p) = 365p 1. The expected value of the lottery is 4p - (1 - p) = 5p - 1, giving a risk premium of R(p) = 5p-1-65p - 1. (b) Now suppose that, instead of the utility function above, Bob is risk-neutral. An un- scrupulous raffle saleswoman makes Bob the following offer. For 50 cents, she will tell him whether the ticket for sale will win or lose before Bob decides whether to buy it. If p = 1, will Bob accept the saleswoman's offer? Assume that there is only one ticket available for him to purchase. Solution: Bob has three options: accept the offer, reject the offer and buy a ticket, or reject the offer and not buy a ticket. Since Bob is risk-neutral, he cares only about maximizing the expected value of the lottery he chooses (i.e. we can suppose that u(x) = r). If he rejects the offer, the expected value associated with buying a ticket is 5-1= 0.25 > 0, so he prefers to buy a ticket. If he accepts the offer, then he loses 50 cents for sure, but gains 4 with probability, giving expected value 1-0.5 = 0.5> 0.25. Therefore, Bob will accept the offer.
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