PROFESSOR: Let's consider another lottery.

This lottery is similar to the original one in the sense

that it has the same expected payoff.
And you can verify that.
But it is more risky.
So the standard deviation of the payoff of this lottery
is higher.
You could see that the first one, the first payoff, I
increase it from $80,000 to $89,000,
and I've decreased the bottom one from $5,000 to $3,500.
So this would make this lottery more risky.
What I want to understand here is
how the certainty equivalence changed for investor A, the one
with the linear utility function, and for investor C.
This was the one who is the most risk averse here.
Let's start with investor A. So first
we compute the expected utility that this investor gets
from this lottery.
So this would be $17,000.
This is by construction.
I constructed this lottery to be as such.
Now, if we want to find certainty equivalent
for this investor, recall that this investor
has linear utility functions.
So the certainty equivalent of this investor is just $17,000.
So therefore this investor is indifferent between taking
$17,000 and this lottery.
And therefore, these investor has exactly the same certainty
equivalent as with the previous lottery,
although these lottery is riskier.
This happens because this investor is risk neutral.
She doesn't care about the fact that these lottery is riskier.
And this is illustrated by the fact
that certainty equivalent for this investor is the same.
Now let's consider the next investor,
the one who is risk averse.
The expected utility from this lottery for this investor
is given by this equation.
If we compute this, this would give us 21.72.
Now, if you find the certainty equivalent--
so certainty equivalent is going to be
equal to 21.72 raised to the power 3,
and so this would be equal to $10,243.43.
So for this investor, the certainty equivalent decreases.

And this is expected, because this investor is risk averse.

In this case, she's presented with a lottery that
has exactly the same expected payoff,
but it is a risky lottery.
And because this investor is risk averse,
it stands to reason that the certainty equivalent,
or the guaranteed amount that this investor will
be willing to trade for this lottery, decreases.
And this is what we see by doing these calculations.