The following questions use the information below.
A decision maker is faced with two alternatives. The decision maker has determined that she is indifferent between the two alternatives when p = 0.45.

-Refer to Exhibit 14.7. What is the decision maker's risk premium for this problem?
A)-$20,000
B)-$25,900
C)$70,000
D)$80,000

Question

The following questions use the information below.
A decision maker is faced with two alternatives. The decision maker has determined that she is indifferent between the two alternatives when p = 0.45.
 
-Refer to Exhibit 14.7. What is the decision maker's risk premium for this problem?
A)-$20,000 
B)-$25,900 
C)$70,000 
D)$80,000

Quizplus · Accepted Answer

The decision maker's risk premium is the amount of money she would be willing to pay to eliminate uncertainty and guarantee the better outcome. In this case, her indifference point is at p = 0.45, meaning she is equally happy with either option when there is a 45% chance of success. To calculate the risk premium, we need to find the difference between the expected payoffs of the two options and multiply it by the probability of the unfavorable outcome.

The expected payoff of option 1 is (0.35 x $80,000) + (0.65 x $20,000) = $44,000. The expected payoff of option 2 is (0.65 x $70,000) + (0.35 x $0) = $45,500. The difference between these payoffs is $1,500.

Therefore, the risk premium is 0.55 x $1,500 = $825, which means the decision maker would be willing to pay up to $825 to choose the option with the guaranteed payoff. Option B is the best choice because it offers a guaranteed payoff of $25,900, which is $825 less than the expected payoff of option 2.

The Following Questions Use the Information Below