1. What is a Certainty Equivalent?

Imagine someone offers you a gamble:

• You flip a coin.

  • If it’s heads, you get $100.

  • If it’s tails, you get nothing.

This is a 50/50 bet — on average, it’s worth $50(sincehalfthetimeyou’dget$100, half the time $0). But here’s the question:

Would you take the bet, or would you rather just get a guaranteed amount of money instead?

You might say:

• “This makes me nervous. Just give me $40 for sure and I won’t take the gamble.”

That $40 is your certainty equivalent — it’s the amount of guaranteed money that feels just as good to you as the uncertain bet.

✅ The certainty equivalent shows how comfortable you are with risk.

• If you’re willing to take less than the average just to avoid uncertainty, you’re risk-averse.

• If you’d only accept exactly $50, you’re risk-neutral.

• If you ask for more than $50, you’re risk-seeking (you actually enjoy the risk!).

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2. What is Risk Aversion?

Risk aversion is just a fancy way of saying:

“How much do you dislike uncertainty or taking risks?”

Some people hate risk. Others don’t mind it — some even like it (think of gamblers or entrepreneurs).

Let’s use a simple example:

You have $100 in your pocket. Someone offers you a chance to:

• **Risk $10\ast \ast forasmallchancetowin$50.

A risk-averse person might say:

“No thanks, I’d rather keep my $10.”

A less risk-averse person might say:

“Sure, I’ll take the chance — it could be fun!”

We all feel differently about risk, and that’s what the “risk aversion coefficient” tries to capture:
How strong is your dislike for risky situations?

In practice, economists and financial professionals try to estimate this so they can:

• Design better investments for people

• Understand why some people prefer insurance or savings, while others buy lottery tickets or start risky businesses

• Risk-averse when dealing with gains (take the sure thing)

• Risk-seeking when dealing with losses (gamble to avoid the loss)

But both come from loss aversion — they really hate the idea of losing value.

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Loss aversion means people feel the pain of a loss more intensely than the pleasure of an equivalent gain. Option D exemplifies this perfectly. The bet presents a 60% chance of losing $100,whichisapotentialloss.Eventhoughther{e}^{\prime }sa40$60 loss to avoid the potential for a larger loss.