Answer Key to Week 6 Discussion

1. a) You’re mom will be risk-averse if the expected value of the suitcase is more than the
banker’s offer. To find the expected value,
E(suitcase) = (Probability of happening) * (value if it happens)
= (1/5) ($4) + (1/5)($49) + (1/5)($625) + (1/5)($4,900) + (1/5)($62,500)
= $13,615

Since the bankers offer is $2,500, this means your mom is risk-averse.

b) You are comparing your utility from getting $2,500 for sure, to your utility in each of the
possible cases, multiplied by the probability of it happening:
Take the offer: U($2,500) = sqrt($2,500) = 50 utils
Don’t take the offer: U(suitcases) = (1/5)*sqrt($4) + (1/5)*sqrt($49) + (1/5)*sqrt($625) +
(1/5)*sqrt($4,900) + (1/5)*sqrt($62,500)
= (1/5)*2 + (1/5)*7 + (1/5)*25 + (1/5)*70 + (1/5)*250
= 70.8 uitls

Therefore you should not take the offer, and gamble with your choice of suitcase.

c) You do take this option. To determine this, look at your utility if you were to pick this
suitcase = U($6,400) = 80 utils. Since this is higher than your original expected utility, you will
increase your expected utility with this option. An explanation of why you like this option is
that it reduces the chances you get one the low-payout suitcases, so even though your expected
payoff is lower, your expected utility increases.

d) To find this, you need your utility from taking the offer to equal your expected utility
from choosing the suitcase. As computed in b), your expected utility from taking the suitcase is
70.8 utlis, so set
U(banker offer) = 70.8
Sqrt(Banker offer) = 70.8 so the banker’s offer needs to be (70.8)^2 = $5,012.64

e) Given this new utility, recalculate your expected utility from part b):
U(suitcases) = (1/5)(4^2) + (1/5)(49^2) + (1/5)(625^2) + (1/5)(4,900^2) + (1/5)(62,500^2)
= (1/5) (16+ 2,401 + 390,625 + 24,010,000 + 3,906,250,000)
= 786,130,608.4 utils

So now, as in d), find which banker’s offer equals this utility:

U(banker offer) = 786,130,608.4
(banker offer)^2 = 786,130,608.4
Banker offer = $28,038
The reason the banker’s offer needs to be so much higher now to make you indifferent is that
you get much more enjoyment now from big wins relative to smaller wins, so instead of just
being happy to get something, you now need to be guaranteed a significantly higher amount to
take away that potential big enjoyment you’d get from the suitcases.

However, the banker only cares about how much money is won or loss, and thus he is risk-
neutral, so his utility function would be U(offer) = W. This means he only cares about whether
the expected prize is higher or lower than his offer. Since the expected prize from the suitcases
is $13,615, his highest offer would ever be $13,615.