ECON204: Problem Set 5

Problem Set 5
Choice under Uncertainty

Frank, 4th Edition:

Do 9, 10, 11, 15 and 19 a. b. in Problems, pp. 195 – 197.

Frank, 3rd Edition:

Do 9, 10, 11, 15 and 19 a. b. in Problems, pp. 243 – 244.

Multiple-choice Questions:

1. An individual is risk-averse if:

a) The certainty equivalent of a prospect is greater than the expected monetary value of the
gamble.
b) The expected utility of the gamble is larger than the utility of the expected value of the
gamble.
c) The utility of the certainty equivalent is greater than the utility of the expected value of the
gamble.
d) He is not willing to take a gamble at a price equal to the expected monetary value of the
gamble.
e) None of the above.

2. My friend sells $20 phone cards. One-quarter of them are defective, and will not work, but I cannot
tell which ones are defective. Ignoring the possible legal and moral issues involved, and assuming I
am risk neutral, I will be willing to pay my friend $ for a $20 phone card.
a) 20
b) 15
c) 10
d) 5
e) 0

3. If I am a risk seeker and am faced with the same $20 phone card selling friend as described in
question 2 above, my answer will be:
a) greater than the answer given above.
b) less than the answer given above.
c) the same as the answer given above.
d) one of the three listed above, but the right one cannot be known until the degree of risk loving
is determined.
e) None of the above.

4. If a risk-averse person insures (by paying their risk premium) for every tiny risk that is anticipated,
a) her utility will be higher than if she had not insured.
b) she will be worse off in expected utility terms because insurance companies pay out less than
the expected value received by self-insuring.
c) she will be at the same utility level as she would be without insurance on the tiny risks.
d) she will be likely to have more accidents even if there is no moral hazard present.

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 ECON204: Problem Set 5

Additional Problems:

1. Betty Bat loves the Vancouver Canucks. She has followed their exploits since she was five years old
and believes they will win the Stanley Cup this season. She has $1,000 savings that she has hidden
under her bed. She could spend $600 of the $1,000 in making Canucks championship paraphernalia:
buttons, cups pens and so on. Then, if the Canucks win, she estimates her total revenue would be
$1,500. If the Canucks lose, she won’t be able to sell any of her stock. Betty figures that the Canucks
have a 0.6 chance of winning the Stanley Cup. Her utility function is given by u (M ) = M .

a) Will Betty make the $600 investment into Canucks championship gadgets?

b) Calculate the certainty equivalent of Betty’s prospect.

c) Suppose that a friend offer Betty insurance. He says to Betty, “If you pay me F dollars
whether or not the Canucks win, then in the event that the Canucks lose, I will pay you
$1,500, the amount that you would have earned had the Canucks win the Stanley Cup. If the
Canucks win, I will pay you nothing.” What is the maximum value of F that Betty is willing
to pay for the insurance policy? If Betty’s friend is risk neutral, will he gain by this venture?
Explain.

2. Suppose that your family owns a farm whose assets are worth $250,000. Adding last year’s earnings
of $200,000, your family’s wealth has grown to $450,000 at the beginning of the planting season of
summer corn. You, being the brightest in the family, must choose between sitting this season out and
investing last year’s earnings of $200,000 in a safe money market fund paying 5.0% per year, or
planting summer corn. Planting costs $200,000, with a six month time to harvest. If there is rain,
planting summer corn will yield $500,000 in revenues at harvest. If there is a drought, planting will
yield $50,000 in revenues. As a third choice, you can purchase AgriCorp drought-resistant summer
corn at a cost of $250,000 that will yield $500,000 in revenues at harvest if there is rain, and $350,000
in revenues if there is a drought. You are risk averse, and your preference for family wealth (W) is
specified by the relationship u (W ) = W . The probability of a summer drought is 0.30, while the
probability of summer rain is 0.70.

Question: Which of the three options should you choose?