8. Risk aversion in the two-state model Aa Aa Suppose Ginny and Stan each own ca

Question

8. Risk aversion in the two-state model Aa Aa Suppose Ginny and Stan each own catering businesses in the town of Yorkville. Each year, the mayor of Yorkville throws a huge party catered either by Ginny or Stan, depending on the mayor's mood. Outside of the party, Ginny earns $25,000 and Stan earns $50,000 in profits each year, but the one who caters the mayor's party gets an additional $50,000 in profits. The following graph presents Ginny's indifference curves (labeled G1, G2, and G3) between the two potential states of the world: one in which Ginny gets the contract (call this the G-contract state) and one in which Stan gets the contract (the s-contract state). Place the red point (cross symbol) on the graph to indicate Ginny's gamble. PROFIT IN S-CONT. STATE (Thousands of dollars] 150 Certainty Line Ginny's Gamble 125 G3 G2 Ginny's New Point G1 100 75 50 25 25 50 75 100 25 150 PROFIT IN G-CONT. STATE IThousands ofdolars Help Clear All

Explanation / Answer

As the indifference of Ginny is relatively flat compare to Stan , so we can say Ginny is relatively more risk averse than Stan. As Marginal rate of substitution will be higher for Stan as it is relatively steeper.

So, Because Ginny is relatively more risk averse than Stan, this new aggrement will have a less relative impact on her utility compared with the impact of Stan's utility.

Now why there will be less impact, if Ginny be more risk averse, it does not matter to which the contract goes. In case of without aggrement Stan will have always go for because Stan is relatively less risk averse than Ginny. The one who takes the littlebit, he or she can have a chance more utility. So, after aggrement there is a more loss to Stan and the impact on Stan is going to be more. Impact on Ginny is going to be less.

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