Question 1

Mel is thinking of going on a cruise. Mel values a cruise in nice weather at $2,000 and values a cruise in bad weather at $50. The probability of nice weather is 60% and the probability of bad weather is 40%. Trip insurance is sometimes available. If purchased, it allows travelers to delay the cruise until the weather is nice. The amount of money that Mel is willing to pay for trip insurance will be:

Accepted Answer

The probability and values for nice and bad weather are fixed, so Mel's willingness to pay for trip insurance should not be affected by her risk preferences. Therefore, her willingness to pay remains the same regardless of whether she is risk-averse or risk-neutral.

Question 2

Pascal is risk-averse while Marion is risk-neutral. Both are confronted with the following gamble: win $5,000 with the probability of 65% or lose $9,000 with a probability of 35%. One can predict that:

Accepted Answer

The answer of Pascal is risk-averse while Marion is risk-neutral....

Question 3

Lou and Toby both live in a little town and are trying to sell their cars. Both of their cars have a blue book value of $10,000. Lou has an American car like most of the people in town own. Toby owns the only Bulgarian car in town. If people in their town are risk averse, then who will get closest to the blue book value for his car?

Accepted Answer

Since people in their town are risk averse, they will prefer to buy Lou's American car because it is a familiar and common make in the town. This familiarity and commonness will reduce the perceived risk associated with the purchase of Lou's car, and he will get closest to the blue book value for his car. Toby's Bulgarian car, on the other hand, is unique and unfamiliar to the people in the town, which increases the perceived risk associated with its purchase, and he will not get as close to the blue book value for his car as Lou.

Question 4

Suppose Vinnie is looking for a month-long vacation rental in San Diego. The first vacation rental Vinnie finds costs $800 per month. If he looks for another vacation rental, there's a 75 percent chance he'll find another one for $800 per month and a 25 percent chance he'll find one for $600 per month. Other than price, all of the vacation rentals are identical. Vinnie's marginal cost of searching for an additional vacation rental is $45. For Vinnie, the expected value of searching for another vacation rental is:

Accepted Answer

If Vinnie searches for another vacation rental, there's a 75 percent chance he'll find another one that's the same price and a 25 percent chance he'll save $200. Thus, the expected value of search is: $5 = (0.75)($0)+ (0.25)($200)- $45.

Question 5

A gamble that offers a 1 percent chance of winning $699.93 and a 99 percent chance of losing $7.07 would be classified as a(n):

Accepted Answer

The expected value of this gamble is $0 = (0.01)($699.93)+ (0.99)(-$7.07). Hence, this is a fair gamble.

Question 6

If a gamble has an expected value of $10, then one can predict that:

Accepted Answer

Since the expected value is positive ($10), risk-neutral individuals would be willing to take the gamble as they are indifferent to risk and only concerned with the expected outcome. Risk-averse individuals may avoid the gamble, as they prioritize avoiding a potential loss over a potential gain. Therefore, not all risk-averse people will avoid the gamble.

Question 7

Cal has a choice between two gambles. The first gamble offers a 50 percent chance of winning $20 and a 50 percent chance of losing $20. The second gamble offers a 20 percent chance of winning $100 and an 80% chance of losing $20. Which choice has the higher expected value?

Accepted Answer

The expected value of the first gamble is $0 (= 0.50 × $20 - 0.50 × $20).  The expected value of the second gamble is $4 (= 0.20 × $100 - 0.80 × $20).

Question 8

A risk-neutral individual will:

Accepted Answer

A risk-neutral individual is indifferent to risk and makes decisions solely based on expected value. Therefore, they would accept only gambles with an expected value of zero or greater, as this would lead to the highest expected return, regardless of the amount of risk involved.

Question 9

Suppose someone offers Max the following gamble: with probability 0.50 he will win $10 and with probability 0.50 he will lose $8. The expected value of this gamble is:

Accepted Answer

The expected value of this gamble is $1 = (0.50)($10)+ (0.50)(-$8).

Question 10

Mel is thinking of going on a cruise. Mel values a cruise in nice weather at $2,000 and values a cruise in bad weather at $50. The probability of nice weather is 60% and the probability of bad weather is 40%. Trip insurance is sometimes available. If purchased, it allows travelers to delay the cruise until the weather is nice. Suppose that the price of the cruise is $1,200. If Mel is risk-neutral, then Mel should:

Accepted Answer

The expected value of the cruise without insurance is $1,220 (0.6 * $2,000 + 0.4 * $50). Mel should buy insurance if it costs less than the difference between this expected value and the cruise price, which is $780 ($2,000 - $1,220).

Question 11

Curly is offered the following gamble: a 25% chance of winning $1,500 and a 75% chance of losing $500. This is a(n):

Accepted Answer

The expected value of the gamble is (0.25 * $1,500) + (0.75 * -$500) = $375. Since the expected value is positive, the gamble is fair.

Question 12

A risk-averse individual will:

Accepted Answer

A risk-averse person will only accept better-than-fair gambles. They will refuse any fair gamble.

Question 13

A 65% chance of winning $10 and a 35% chance of losing $5 would be classified as a(n):

Accepted Answer

A better-than-fair gamble is one where the expected value is positive, meaning that the potential gains outweigh the potential losses. In this scenario, the expected value would be:

(0.65 x $10) + (0.35 x -$5) = $6.50 - $1.75 = $4.75

Since the expected value is positive, this would be considered a better-than-fair gamble.

Question 14

Suppose Chris is offered the following gamble: with probability 0.1 he will win $90, with probability 0.4 he will win $50, and with probability 0.5 he will lose $60. Chris will:

Accepted Answer

To solve this problem, we need to calculate the expected value of the gamble.

The expected value is:

0.1(90) + 0.4(50) + 0.5(-60) = 9 + 20 - 30 = -$1

Since the expected value is negative, Chris should not accept the gamble if he is risk-neutral. Therefore, the answer is D.

Question 15

Suppose Chris is offered the following gamble: with probability 0.1 he will win $90, with probability 0.4 he will win $50, and with probability 0.5 he will lose $60. The expected value of this gamble is ______.

Accepted Answer

The expected value of a gamble is the sum of the products of the possible outcomes and their probabilities. In this case, the expected value is:(0.1 * $90) + (0.4 * $50) + (0.5 * -$60) = $9 - $20 - $30 = -$1

Question 16

Suppose Chris is offered the following gamble: with probability 0.1 he will win $90, with probability 0.4 he will win $50, and with probability 0.5 he will lose $60. The expected value of this gamble is found by solving:

Accepted Answer

The expected value of a gamble is found by multiplying each possible outcome by its probability and then taking the sum of these products. Using the given probabilities and outcomes, we get:

0.1 × $90 + 0.4 × $50 - 0.5 × $60 = $9 + $20 - $30 = $-1

Since the expected value is negative, it is not a good idea for Chris to take this gamble. Therefore, he should not choose any option, as all of them involve taking the gamble.

Question 17

Suppose Mo is considering whether to see Zombie Revenge III at her local movie theater. Tickets cost $12 each, but Mo isn't sure how much she's going to like the movie. There's a 40 percent chance she'll get $20 worth of enjoyment from seeing the movie, and there's a 60 percent chance she'll only get $10 worth of enjoyment from seeing the movie. Mo's expected value of seeing the movie is:

Accepted Answer

The expected value of seeing the movie is $2 = (0.40)($20)+ (0.60)($10)- $12.

Question 18

Mel is thinking of going on a cruise. Mel values a cruise in nice weather at $2,000 and values a cruise in bad weather at $50. The probability of nice weather is 60% and the probability of bad weather is 40%. Trip insurance is sometimes available. If purchased, it allows travelers to delay the cruise until the weather is nice. If Mel is risk-neutral, then in the absence of trip insurance, the most she will be willing to pay for the cruise is _______.

Accepted Answer

Since Mel is risk-neutral, her expected utility from the cruise is simply the expected value of the utility of the two possible outcomes. 
Expected utility (without insurance) = 0.6($2,000) + 0.4($50) = $1,210

Since Mel is only willing to pay for the cruise if her expected utility is at least $1,210, the maximum amount she will be willing to pay is $1,220, which is the highest amount that still yields an expected utility of at least $1,210. Therefore, the best choice is (C) $1,220.

Question 19

Consider the gamble inherent in looking for an apartment. If the expected value of going to see another apartment is zero, then:

Accepted Answer

If the expected value is zero, a risk-averse person will not see the next apartment. A risk-averse person will refuse any fair gamble.

Question 20

Suppose Vinnie is looking for a month-long vacation rental in San Diego. The first vacation rental Vinnie finds costs $800 per month. If he looks for another vacation rental, there's a 75 percent chance he'll find another one for $800 per month and a 25 percent chance he'll find one for $600 per month. Other than price, all of the vacation rentals are identical. Vinnie's marginal cost of searching for an additional vacation rental is $45. Since searching for another apartment is a ______ gamble, if Vinnie is risk-neutral, then he ______ search for another apartment.

Accepted Answer

The expected value of search is: $5 = (0.75)($0)+ (0.25)($200)- $45. Since this is greater than zero, we know that searching is a better-than-fair gamble, and a risk-neutral person will accept any better-than-fair gamble.

Quiz 11: The Economics of Information