Question

Anne has been given a choice between two lotteries. In lottery A a fair coin is flipped. If it comes up heads, Anne wins $50, if it comes up tails, she wins $150. In lottery B a fair coin is also flipped. If it comes up heads, Anne wins nothing, if it comes up tails, she wins $200. Evaluate the statements,

a) If Anne is risk loving, she prefers lottery A to lottery B (True, False). Explain.

b)If Anne is risk neutral she is indifferent between the two lotteries (True, False). Explain.

Answer 1

Expected payoff from lottery A = 1/2(50) + 1/2(150) = 100

and expected payoff fom lottery B = 1/2(0) + 1/2(200) = 100, where probability of heads = probability of tails = 1/2.

a) False. If Anne is risk loving, she will prefer lottery B to lottery A. This is because in lottery B, there is a possibility of winning $200 as the maximum amount (although at a higher risk, but she is risk-loving) while the maximum amount in lottery A is $150.

b) True. If Anne is risk neutral, she will be indifferent between the two lotteries. This is because both have the same expected payoff.