Gambling on the World Series

Former baseball great Pete Geranium is considering a bet on the outcome of the World Series between the Yankees and the Marlins. His local bookie, Jimmy, has offered him the following deal: if Pete bets $1 on the Marlins and the Marlins win, Jimmy will return Pete’s bet and pay him an additional $2. However, if the Yankees win, Pete loses his bet. Before betting, Pete’s initial wealth is $100.

1. Graph Pete’s budget constraint showing his consumption possibilities in the two states of the world: Yankees win (Y) and Marlins win (M). Put his consumption in state Y on the horizontal axis.
2. Suppose Pete has inside information and knows that the probability of the Marlins winning is 40%. Assuming he is risk neutral, add his indifference curves to the graph from part (1).
3. Given the information in part (2), what is the expected value of a $1 bet? Is the bet actuarially fair? How much would Pete bet? Draw Pete's decision tree for a $1 bet.

Solution