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Expected utility maximiser with utility function

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Reference no: EM133235902

Penny is an expected utility maximiser with utility function u(x)=ln(x) and wealth of $300.

Paddy makes decisions in accordance with prospect theory, has wealth $300 and value function:

v(x)={x12wherex≥0-2(-x)12wherex<0

Penny and Paddy are offered the following bet A:

a 60% probability to win $150

a 40% probability to lose $100.

a. Does Penny or Paddy accept bet A? [3 marks]

b. Following some bad economic news, each of Penny and Paddy's wealth declines to $150. Paddy cannot get over the loss, so his reference point remains his former wealth of $300.

Penny and Paddy are offered bet A again. Does Penny or Paddy accept the bet?

c. For the bets in parts a) and b), draw a diagram (or two diagrams) showing Paddy's value function, the bets and the value of the bets. Explain how the diagram(s) show whether Paddy accepts or rejects the bet.

Reference no: EM133235902

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