Question

Harry's relationship between Utility(U) and income (Y) is represented in the table below U(Y) 36 40 46 54 64 76 90 106 Y 4 10 12 14 16 (a) Draw Harry's utility function with Y on horizontal axis and UCY) on the vertical axis using the graph paper. e will (b) Suppose Harry is offered a gamble where with probability 0.5 he will receive 6 and with 0.5 h receive 14. What is the expected value (EY) of this bet? What is the expected utility with the bet? (c) Is Harry Risk Neutral/ Risk averse/ Risk Loving? Explain (d) Using the diagram in (a) approximate how much Harry would need to be paid/ pay to avoid the bet. Explain your answer.

Answer 1

Answer a) answer b) EY of gamble = .5*6 + .5*14 = 3+7 = 10

Expected utility EU = .5* U(6) + .5*U(14)

= .5*46 + .5*90 = 23+45 = 68

Answer c) since shape of utility function is convex, hence individual is Risk Loving.

D) determining the Certainty equivalent ( CE) of the gamble =

Need to find the income level at which utility is 68

Since risk lover, thus CE > EY

It is approximately equals to $ 10.68