Alex, who is risk-neutral, is looking for an one-bedroom apartment to rent for the month of August while he's on vacation in Seattle. All of the one-bedroom apartments in the neighborhood where he wants to stay are of equal quality, but 70 percent rent for $700 per month, 20 percent rent for $600 per month, and 10 percent rent for $500 per month. The first apartment Alex finds rents for $700 per month. If the cost to Alex of searching for an apartment is $30, then searching for another apartment is a gamble with an expected value of:

Question

Quizplus · Accepted Answer

Since Alex is risk-neutral, he bases his decisions solely on expected value. The expected value of the first apartment Alex finds is simply $700, since there's no uncertainty involved.

To determine the expected value of searching for another apartment, we need to take a weighted average of the possible outcomes. The expected value is:

(0.7)($700) + (0.2)($600) + (0.1)($500) - $30
= $490 + $120 + $50 - $30
= $630

So the expected value of searching for another apartment is $630. Since this is higher than the expected value of the first apartment ($700), it's rational for Alex to continue searching. However, the gamble involved is only worth an expected value of $10 ($630 - $620), which may not be worth it depending on Alex's personal preferences. Therefore, the best choice is to keep searching (B) if Alex values the possibility of saving $70 ($700 - $630) more than the cost of the gamble ($10).

Alex, Who Is Risk-Neutral, Is Looking for an One-Bedroom Apartment