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 $40, then searching for another apartment is a gamble with an expected value of:

Question

Quizplus · Accepted Answer

Since Alex is risk-neutral, his decision will be based solely on expected value. The expected value of searching for another apartment can be calculated as follows:

EV = (0.7 * 700) + (0.2 * 600) + (0.1 * 500) - 40
EV = 490 + 120 + 50 - 40
EV = 620

Since the expected value of searching for another apartment is positive, Alex should continue to search. However, he should not gamble further and settle for the apartment he finds next, regardless of its price, as the expected value of that decision would be negative. Therefore, the best choice is to continue searching until he finds an apartment other than the first one, then rent it immediately.

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