Riskier investments generally have higher returns. One explanation for this is risk aversion on the part of investors. Risk aversion means that investors generally prefer to avoid risk and, for example, would pay more for an asset that pays $10,000 for sure than for one that pays $0 half of the time and $20,000 the other half of the time.
Suppose that potential investors are considering buying or building homes in Vermont as an investment. Investors expect that, with 50% probability, these homes will be worth $100,000 in five years and that, with 50% probability, they will be worth $140,000 in five years. On average, then, investors think that the homes will be worth $120,000 in five years. In these conditions, investors buy 1,000 homes at a price of $100,000 each.
Suppose that houses in Vermont become riskier-in particular, homes will be worth $60,000 in five years with a 50% probability and $180,000 in five years with a 50% probability. The expected price in five years is still $120,000.
a. If investors are risk-averse, and the supply curve for homes in Vermont is upward-sloping, which combination is a possible new price and quantity of investment houses bought in Vermont?
A possible combination is
a. P =S90,000, Q = 900
b. P =$110,000, Q = 900
c. P =$100,000, Q = 1000
d. P =$110,000, Q = 1, 100
e. P =$90,000, Q = 1, 100