Chapter1: Making Economics Decisions
Section: Chapter Questions
Problem 1QTC
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2
![For L2 slide 21, if u(9) = 55 what is the risk premium?
$2.5
$3.5
O s0
O $1.50
Slide 21 show below:
• Suppose we have a bet with x is wealth and U(x) is your utility of that wealth:
• 50% chance of receiving 25
• 50% chance of receiving 0
EV = (0.5)(0) + (0.5)(25) = $12.5
• And if the person has the utility function with
u(0) = 10, u(7.5) = 55 , u(25)=100
arco
E[U(w)] = 0.5 U(0) + 0.5 U(25)= 55
%3D
• The certainty equivalent is $7.5, the amount that makes you indifferent to the
expected utility of the bet
The risk premium is ($12.5 - $7.5) = $5
• This risk premium means that the person would be willing to sacrifice as much
as $5 in expected value in order to achieve perfect certainty about how much
money will be received](/v2/_next/image?url=https%3A%2F%2Fcontent.bartleby.com%2Fqna-images%2Fquestion%2F1b956937-a9b2-46b9-9651-5aaca3a62e19%2F4f2bb574-0c42-4ad4-bba5-08b951e5818d%2Fzsvig3g_processed.jpeg&w=3840&q=75)
Transcribed Image Text:For L2 slide 21, if u(9) = 55 what is the risk premium?
$2.5
$3.5
O s0
O $1.50
Slide 21 show below:
• Suppose we have a bet with x is wealth and U(x) is your utility of that wealth:
• 50% chance of receiving 25
• 50% chance of receiving 0
EV = (0.5)(0) + (0.5)(25) = $12.5
• And if the person has the utility function with
u(0) = 10, u(7.5) = 55 , u(25)=100
arco
E[U(w)] = 0.5 U(0) + 0.5 U(25)= 55
%3D
• The certainty equivalent is $7.5, the amount that makes you indifferent to the
expected utility of the bet
The risk premium is ($12.5 - $7.5) = $5
• This risk premium means that the person would be willing to sacrifice as much
as $5 in expected value in order to achieve perfect certainty about how much
money will be received
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