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Differences in Risk Preference

Autor:   •  May 22, 2015  •  Course Note  •  362 Words (2 Pages)  •  721 Views

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Differences in risk preference

- In the previous section, it was assumed that everyone maximized expected value.

- However, people often pay to avoid risk, whether by purchasing insurance or by sacrificing some potential "upside" for a bit more security, and there are substantial individual differences in the tendency to tolerate risk.

- Such differences can be exploited to create joint gains.

- Example

: Two business partners, Hank and Ida, own equal shares in a venture that has a 50% chance of becoming a bonanza. If the venture goes bonanza, Hank and Ida will be rewarded with $1,000,000 in profits. If the venture fails to go bonanza, the venture will just break even, producing no profit.

- There are not differences in opinion to exploit, only differences in willingness to tolerate risk.

- Hank is extremely risk averse, cautious in his personal and business finances.

- Ida, on the other hand, is glad to make decisions, even large stakes ones, on the basis of expected value.

- Case 1(each getting half of the proceeds)

: Hank and Ida each get half of the proceeds, in all cases. In other words, Hank and Ida will each receive $500,000 if the venture goes bonanza, and nothing otherwise.

venture goes bonanza venture fails

Value

.50 .50

Hank's payment $500,000 $0 $250,000

Ida's payment $500,000 $0 $250,000

Total payment $1,000,000 $0

- Case 2(exploiting differences in risk preferences)

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