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# disc5 - DISCUSSION SECTION 5 Risk and Uncertainty-Expected...

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DISCUSSION SECTION 5 Risk and Uncertainty ------------------------------------------------------------------------------------------------------------ Expected Utility : ) ( ... ) ( ) ( 2 2 1 1 N N x U p x U p x U p EU × + + × + × = , 1 1 = N i p ------------------------------------------------------------------------------------------------------------ A premium is a payment to an insurance company in return to a commitment to pay a claim in a possible future event. A fair insurance is an insurance policy for which the premium is equal to the expected value of the claim. ------------------------------------------------------------------------------------------------------------ An individual is risk-averse if he strictly prefers a certain payment to an uncertain payment with the same expected value. Risk-averse individuals have diminishing marginal utility. ------------------------------------------------------------------------------------------------------------ QUESTION 1 Maria has invested her savings to a lottery. Next week, there is a 25% chance that she will get \$400, otherwise she will get \$1,600. Her utility is given by: x x U = ) ( . a. What is Maria’s expected income next week? b. What is her expected utility? c. What is Maria’s expected utility if she received the value of the expected income with probability one? Is it smaller or bigger than the value in part b? Is Maria risk-averse, risk- neutral or risk-lover?

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disc5 - DISCUSSION SECTION 5 Risk and Uncertainty-Expected...

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