Question

Consider a lottery with three possible outcomes: Payout $2000 $1000 $0 Probability .1l 4 .5 Answer questions 1-2 with reference to the information above 1. What is the expected payout from this lottery? a. $100 b. $200 c. $350 d. $450 e. $600 2. Which of the following is true with reference to Mike's willingness to participate in this gamble? a. If Mike is willing to pay at most $500 to participate in this gamble then he is risk neutral b. If Mike is willing to pay at most $400 to participate in this gamble then he is risk averse c. If Mike is willing to pay at most $600 to participate in this gamble then he is risk averse d. If Mike is willing to pay at most $650 to participate in this gamble then he is risk neutral e. If Mike is willing to pay at most $450 to participate in this gamble then he is risk seeking **

Answer 1

1. The expected payout from this lottery is E(X) = .1*$2000 + .4*$1000 = $(200+400) = $600

Hence, the option e) is correct.

2. if Mike is willing to pay at most $600, then he is risk neutral. So, option a), c) and d) are incorrect.

People who would like to pay less than the expected return from the gamble are called risk averse. Here if Mike is willing to pay $400, he is paying less than the expected payout from the lottery. Hence, he is risk averse.

So, option b) is correct.