2. Recall the \"wishful thinking model from Lecture 17. Suppose an investor has

Question

2. Recall the "wishful thinking model from Lecture 17. Suppose an investor has 3 available actions: put everything in the bank (call this the "safe" action), split his investment between the bank and the stock market (call this the "moderate action), or put everythig n the stock market (call this the risky action) His utilities are as follows, depending on whether the good state (boom) or bad state (recession) occurs: bad state good state 10 12 16 safe 10 moderate6 risky 10 (a) Calculate his expected payoff from each action if he (wishfully) expects the bad action to happen with probability p.

Explanation / Answer

1. His expected payoffs could be calculated as follows,

His expected payoff from putting everything in bank (safe ), Es =10p + (1 - p) 10 = 10

His expected payoff from putting everything in bank and stock market ( moderate ),Em =6p + (1 - p) 12 = 12 - 6p

His expected payoff from putting everything in stock market ( risky ), Er = -10p + (1 - p) 16 = 16 - 26p

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