What does it mean to say that a person is risk averse? O A. The person has diminishing marginal utility of income and prefers a certain income to a gamble with the same expected income. B. The person has increasing marginal utility of income and prefers a certain income to a gamble with the same expected income. O C. The person has diminishing marginal utility of income and prefers an uncertain income to a certain income. D. The person has increasing marginal utility of income and prefers an uncertain income to a certain income. Why are some people likely to be risk averse while others are risk lovers? A. A person's risk aversion (or risk loving) depends only on the person's income. At low levels of income people are risk averse, but at high income they become risk loving. B. A person's risk aversion (or risk loving) depends on the nature of the risk involved, but it is independent of income. C. A person's risk aversion (or risk loving) depends on the nature of the risk involved and on the person's income. D. A person's risk aversion (or risk loving) depends only on the person's income. At low levels of income people are risk loving, but at high income they become risk averse.

6 Consider Bob's utility function. a. What is Bob's expected value of a gamble with a 50% chance of $0 and a 50% chance of $100? 4 d b 30 50 75 100

p Consider the following lottery scenarios. Which of these is an example of the Allais Paradox, a well-known deviation from expected utility theory? O a. Lottery P offers a 1% chance of winning $10,000 and a 99% chance of winning nothing, while Lottery Q offers a 50% chance of winning $200 and a 50% chance of winning nothing. Even though the expected value of Lottery P is greater, most people choose Lottery Q because they overweight the low probability event in P. O b. Lottery M offers a 90% chance of winning $5,000,000 and a 10% chance of winning nothing, while Lottery N offers a 10% chance of winning $50,000,000 and a 90% chance of winning nothing. Despite Lottery N having a higher expected value, a majority of people choose Lottery M. Oc. Lottery X offers a 50% chance of winning $1,000 and a 50% chance of winning nothing, while Lottery Y offers a guaranteed win of $450. Despite the higher expected value of Lottery X ($500 vs $450), a majority of people choose Lottery Y. O d. Lottery…

An individual is oered a choice of either $50 or a lottery which may result in $0and $100, each with equal probability 1/2 . If the individual has a utility function u(w) = 5 + 2w, which one would they choose? If the individual has a utility function u(w) =w1/2 + 1?

1. Risk Premium: Assume your wealth is $100 and like in the Veritassium video you're offered a bet of a 50% chance of winning $10 and a 50% chance of losing $10. Assume you have square root utility. a. What is the utility you enjoy by holding the $100 of current wealth? b. What is the expected utility you foresee by entering the bet? Will you take the bet? c. What is your risk premium? Do you think someone would pay this to avoid the bet? d. Draw a diagram and label the relevant values.