Question

If you search for a better price on a good you'd like to buy, theres a 50% chance you will save 40 dollars, and there's a 50% chance you won't find a better deal. If the cost to you of searching for a better price is $15 and you are risk neutral you should:

Answer: search for a better price. the expected value of this gamble is $5.

How does one find the expected value of the gamble? Please help! Thanks.

Answer 1

It is given that there is a 50% chance of saving $40 and a 50% chance of saving nothing. In both cases, the cost is $15. The expected value can be calculated by multiplying the respective probabilities by the return (including costs). So,

Expected Value = (0.5) (40 - 15) + (0.5) (-15)

Expected Value = (0.5) (25) + (0.5) (-15)

Expected Value = 12.5 - 7.5 = $5

So, the expected value is $5.

It is given that the consumer is risk neutral. Since the expected value for searching a better price is greater than 0, the consumer should search for a better price.