Penny is an expected utility maximiser with utility function u(x)=ln(x) and wealth of $300.

Paddy makes decisions in accordance with prospect theory, has wealth $300 and value function:

v(x)={x12wherex02(x)12wherex<0

Penny and Paddy are offered the following bet A:

• a 60% probability to win $150
• a 40% probability to lose $100.

a) Does Penny or Paddy accept bet A? [3 marks]

b) Following some bad economic news, each of Penny and Paddy's wealth declines to $150. Paddy cannot get over the loss, so his reference point remains his former wealth of $300.

Penny and Paddy are offered bet A again. Does Penny or Paddy accept the bet? [3 marks]

c) For the bets in parts a) and b), draw a diagram (or two diagrams) showing Paddy's value function, the bets and the value of the bets. Explain how the diagram(s) show whether Paddy accepts or rejects the bet. [4 marks]