Question 6: [optional, no extra credit, but worth trying your answer only needs

Question

Question 6: [optional, no extra credit, but worth trying your answer only needs to be a few sentences ta, Suppose Karen is a risk averse expected utility maximizer. As Karen's wealth goes up, will she act more or less risk-averse? Briefly explain your answer (b) Suppose Julian is a risk-averse expected utility maximizer. If he were extremely risk-averse could he prefer the lottery (1000,1) over the lottery (1000, : 1100,3) Briefly explain your an- swer (e) Does the St. Petersburg Paradox suggest that expected utility is a bad model of human behavior? Briefly explain your answer

Explanation / Answer

A. A risk averse is the one who makes investment or participates in a game depending upon the risk factor of the investment. The risk averse person is likely to choose the lower risk with expected returns rather than higher risk and unexpected returns.

Karen would generally see the current income at the time of decision. But when the wealth(accumulated income over time) levels increases, Karen's risk aversion DECLINES relatively. Lower wealth, higher risk aversion. Higher wealth, lesser risk aversion.

B.An extremely risk averse person is likley to never buy a lottery as the return is unexpected and highly risky.But given the question, Julian is more likely to choose (1000,1) as he gets return of 1 for 1000 units rather than getting 1/2 for 1000 or 1/2 for 1100. He wont take the risk of paying 100 more and getting 1/2 or paying 1000 getting only 1/2.

C. The paradox mainly taks about Expected return(value and not utility) being the sole criteria for the decision to participate in the game and hence does not take risk into consideration. The paradox was critised by various economists (Bernoulli ) for being irrational as any person would take into consideration the risk factor. The paradox's assetion that the person will not participate even in a fair game was criticised. This paradox is definitely a bad model of human behaviour as people consider utility more than the returns and are likely to play a fair game.The paradox goes against the basic economic principle of "people respond to incentives".

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