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There are two stocks in an economy. If they buy a share of stock A, they have a 60% chance of getting $50 next year and a 40% chance of getting $30. Stock B has a 10% chance of getting $200 and a 90% chance of getting $31. Assume both stocks cost the same today.
a) If the consumer must buy 2 shares of the same stock, which one will they buy if their utility = U(W) = W1/2. Use the expected income of each stock and how the person feels about risk to justify why B is a riskier stock.
b) If the probabilities of the two stocks are completely unrelated (meaning the probabilities for stock A are unaffected by the outcome of stock B and vice versa. Mathematically, the covariance between stock A and B is 0), show that buying 1 share of each stock is better than your result in (a). (Note: With one share of each stock, there are 4 possible outcomes a year from now. Also remember that the probability of two independent events happening is the product of their probabilities.)
When entrepreneurs are investing their own money, how do they decide which projects they should undertake? When political decision-makers allocate the funds of others (taxpayers), how do they decide which projects to support? Explain.
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The purposes of assessing the consequences of these provisions for strategic decision making.
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