Dr.

Donna Feir
Economics 313

Problem Set 5: Solutions

Uncertainty
1. Calculate the expected values of each of the gambles listed below:

a. A dice roll that pays $1,200 if you roll a 1, $300 if you roll a 2 or a 3, and nothing if you roll
anything else.

EV = (1/6 × 1,200) + (2/6 × 300) + (3/6 × 0) = 200 + 100 + 0 = $300

b. A lottery ticket that pays $1,000,000 with a 1% chance, $50,000 with a 2% chance, and nothing
with a 97% chance.

EV = (1/100 × 1,000,000) + (2/100 × 50,000) + (97/100 × 0) = 10,000 + 1,000 = $11,000

c. You own a home, for which you paid $300,000. With a 5% chance the house will appreciate in
value by 20%, with a 20% chance the house will appreciate in value by 10%, with a 65% chance
the house value will remain constant, and with 10% chance the house depreciate in value by
10%.

EV = (5/100 × 360,000) + (20/100 × 330,000) + (65/100 × 300,000) + (10/100 × 270,000)

= 18,000 + 66,000 + 195,000 + $27,000 = $306,000

2. Consider the following monetary payoffs for two investments, A and B, and the associated
probabilities of earning these payoffs.

Investment A

Probability Payoff

.1 0

.1 40

.2 50

.4 60

.2 100

Investment B gives a monetary payoff of $49 for sure.

 Dr. Donna Feir
Economics 313

a. What are the mean and variance of monetary payoffs from these two investments?

a) Investment A: mean=.1(40)+.2(50)+.4(60)+.2(100)=58

Variance=.1(0-58)2+.1(40-58)2+.2(50-58)2+.4(60-58)2+.2(100-58)2=736
Investment B gives 49 for sure, therefore its mean is 49 and its variance is 0.

b. Which investment has the highest expected monetary payoff?

Investment A.

c. Albert has the following utility function for money: u = 5x.25, where x is the amount of money he
receives. Which of the two investments would he prefer?

We calculate Albert’s expected utility of both investments:

U(A)= .1*5(40.25)+.2*5(50.25)+.4*5(60.25)+.2*5(100.25)= 12.645

U(B)=5(49.25)=13.229

Albert would choose investment B, because his expected utility is higher for investment B.

d. How high would a sure monetary payoff have to be for Albert to make him indifferent between
this amount and investment A?

Albert’s expected utility from investment A needs to be the same as his utility from this sure amount
of money. We already know that his expected utility from investment A is .1*5(40.25) +.2*5(50.25)
+.4*5(60.25) +.2*5(100.25) = 12.645, we therefore need to find which amount for sure gives him the
same utility. That is, the amount for sure, x, would give him U(x) = 5(x.25), and we now want to find
when U(x) =12.645.

Solve 5(x.25)= 12.645, dividing both sides by 5, (x.25)= 12.645/5=2.529 and noting that .25 is equal to ¼,
you need to take both sides to the exponent of 4 to find x: x = 2.5294, and x = 40.91.

That is, if you offer Albert approximately $40.91 for sure, he would be as well off as with investment
A. This result makes sense as we have seen that if he is offered $49 for sure he would be better off
with $49 for sure than with investment A, and therefore we would expect the amount for sure that
makes him indifferent between this amount and investment A to be lower than $49.

e. Britney has the following utility function for money: u = x.5, where x is the amount of money she
receives. Which of the two investments would she prefer?

We calculate Britney’s expected utility of both investments:

 Dr. Donna Feir
Economics 313

U(A)= .1(40.5)+.2(50.5)+.4(60.5)+.2(100.5)=7.1451
U(B)=49.5=7.

Britney would choose investment A, because her expected utility is higher for investment A.

f. How high would a sure monetary payoff have to be for Britney to make her indifferent between
this amount and investment A?

Britney’s expected utility from investment A needs to be the same as her utility from this sure amount
of money. We already know that her expected utility from investment A is
.1(40.5)+.2(50.5)+.4(60.5)+.2(100.5)=7.1451, we therefore need to find which amount for sure gives her
the same utility. That is, the amount for sure, x, would give her U(x) = (x.5), and we now want to find
when U(x) =7.1451.

Solve (x.5)= 7.1451, and noting that .5 is equal to 1/2, you need to take both sides to the exponent of 2
to find x: x = 7.14512, and x = 51.05.

That is, if you offer Britney approximately $51.05 for sure, she would be as well off as with investment
A. This result makes sense as we have seen that if she is offered $49 for sure she would be better off
with investment A, and therefore we would expect the amount for sure that makes her indifferent
between this amount and investment A to be higher than $49.

3. (Risk preferences) Suppose a person faces the following gamble: with probability .25 she receives
$100 and with probability .75 she receives $200. Look/complete the graph below to answer the
following questions:

a. What in the graph below tells you about the person’s attitude towards risk?

The person is risk averse. This can be seen in the graph below because the person’s utility of money is
strictly concave, i.e. her marginal utility of money is decreasing.

b. What is the person’s expected utility of the gamble?

It is equal to .25u(100) +.75u(200) = .25*55 + .75*90 = 81.25

c. Indicate the person’s certainty equivalent in the graph!

In order to find the certainty equivalent, first draw a straight line through the points (100,55) and
(200,90). Then go up at 175 (since the gamble’s expected monetary payoff is 175) until you hit this
line. This is how you find the expected utility of the gamble. Holding expected utility constant, see
where you hit the utility function over sure amounts of money. At this point go down to find out what
the sure amount of money is that gives you the same expected utility as the gamble. This is the
certainty equivalent.
 Dr. Donna Feir
Economics 313

d. If the person would instead of the gamble receive an amount for sure equal to the
expected monetary payoff of the gamble what would be the person’s expected utility?
It’s 83.

4. Clarice is an expected utility maximizer and her utility function over money is given by u = x ½. Clarice’s
friend, Hannibal, has offered to bet with her $1,000 on the outcome of the toss of a coin. That is, if the
coin comes up heads, Clarice must pay Hannibal $1,000 and if the coin comes up tail, Hannibal must pay
Clarice $1,000. The coin is a fair coin, so that the probability of heads and the probability of tails are
both ½. Clarice has $10,000 and is trying to figure out whether she should take the bet. Note that if
Clarice accepts the bet and heads comes up, she will have 10,000-1,000=9,000.

a. If Clarice accepts the bet, then if tails comes up, she will have how much money?

Clarice will have her $10,000 and gets an additional $1,000 if tails comes up: 10,000+1,000=11,000.

b. What is Clarice’s expected utility if she accepts the bet?

.5*(9,000) ½ + .5*(11,000) ½ = 99.875.

c. What is Clarice’s expected utility if she does not accept the bet?

If she does not accept the bet, she’ll always have her $10,000. Her expected utility in this case is
(10,000) ½ = 100.

d. Does Clarice take the bet? Explain why or why not Clarice takes the bet.

If she does not accept the bet, she’ll always have her $10,000. Her expected utility in this case is
(10,000) ½ = 100.
 Dr. Donna Feir
Economics 313

e. Clarice later asks herself, “If I make a bet where I lose all my money, that is all my $10,000 if the
coin comes up heads, what is the smallest amount that I would have to win in the event of tails
in order to make the bet a good one for me to take?” Find the answer to Clarice’s question.

Clarice needs to get at least the expected utility of 100 from this bet, because this is the utility she
obtains from keeping her $10,000. If head comes up, she is left with zero; if tails comes up, she can
keep her 10,000 and gets an additional amount x.

100 = .5*(0) ½ + .5 (10,000 + x) ½

100 = .5 (10,000 + x) ½

200 = (10,000 + x) ½

40,000 = 10,000 + x

x=30,000

Clarice would have to win at least 30,000 in the event of tails coming up in order to make the bet
worthwhile.

5. Suppose that a consumer has the utility of wealth function U(w) = w2. This consumer faces a risky
gamble that pays $100 with chance 3/5 and $200 with chance 2/5.
a. Calculate the expected value of the gamble.

EV = (3/5)(100) + (2/5)(200) = 140.

b. Calculate the utility that this consumer would attain if he were to receive with certainty the
amount you calculated in part a). That is, what is the utility of the expected value of the gamble?

V(EV) = 1402 = 19,600.

c. Now calculate the expected utility of the gamble.

EU = (3/5)(1002) + (2/5)(2002) = 6,000 + 16,000 = 22,000.

d. Compare your answer in part b) to your answer in part c) and use this comparison to draw a
conclusion about this consumer’s risk preferences.

EU > V(EV) ⇒the consumer is risk loving. We could also have reached this conclusion by evaluating the
second derivative of V(w). V’’(w) = 2 > 0 ⇒the marginal utility of wealth is increasing in wealth ⇒the
consumer is risk loving.

e. Calculate the certainty equivalent of the gamble.

We know that the consumer gets EU of 2,000 from the gamble. The amount of money with certainty
that would yield this utility is the certainty equivalent (CE) of the gamble. So we know that V(CE) = CE2
 Dr. Donna Feir
Economics 313

= 22,000 ⇒CE = $148.32. Note that the CE is greater than the EV, which is the opposite inequality to
the case where the consumer is risk averse. Which makes sense, since we know that a risk loving
consumer would prefer a risky gamble to a certain outcome that has the same EV as the risky gamble.

f. Calculate the risk premium of the gamble.

Risk premium = EV – CE = 140 – 148.32 = - 8.32 < 0 (risk loving).

g. Draw a diagram illustrating your answers to part a) through f).

 Dr. Donna Feir
Economics 313

6. (Insurance) Jane owns a house worth $100,000. She cares only about her wealth, which consists
entirely of the house. In any given year, there is a 20% chance that the house will burn down. If it does,
its scrap value will be $30,000. Jane’s utility function is U=x ½.

a. Draw Jane’s utility function.

4
2
money
4 16

b. Is Jane risk-averse or risk preferring?

Jane has a decreasing marginal utility of money. She is therefore risk-averse.

c. What is the expected monetary value of Jane’s gamble?

The expected monetary value of Jane’s gamble is .8*100,000+.2*30,000=86,000.

d. How much would Jane at most be willing to pay to fully insure her house against being
destroyed by fire?

Insurance is guaranteeing Jane the same amount of money whether her house burns down or not.
Therefore the maximum amount she is willing to pay for full insurance is the difference between
100,000 and the amount of money for sure that yields the same expected utility as the gamble. The
expected utility of the gamble is equal to .8*(100,000½)+.2*(30,000½)=252.98+34.64=287.62. The
amount for sure is therefore found by setting Jane’s expected utility from the gamble equal to her
utility if she receives an amount for sure, x: x ½=287.62 and therefore x=287.622=82,725. Thus, Jane is
willing to pay up to 17,275 in insurance premium.

e. Homer is the president of an insurance company. He is risk-neutral and has a utility function of
the following type: U = x. Between what two prices could a beneficial insurance contract be
made by Jane and Homer?

Homer is indifferent between selling insurance and not selling insurance to Jane if the premium is fair,
that is if the premium is equal to the expected damages. This is equal to .2*70,000=14,000. An
insurance premium between 14,000 and 17,275 would make both Jane and Homer better off.
 Dr. Donna Feir
Economics 313

7. Suppose that a consumer owns two assets: a own a house valued at $200,000 and $100,000 in a
money market fund. With probability 10% her house will be destroyed by a fire, leaving her only with
the money market fund (assume the money market fund has zero risk). Her utility of wealth function is
given by 𝑉(𝑤) = ln⁡(𝑤).

a. Calculate the certainty equivalent and the risk premium of the gamble faced by this consumer.

The consumer’s expected utility function is EU = (0.1 X ln wB) + (0.9 X ln wG). At her contingent
endowment, her expected utility is thus equal to 12.502. The certainty equivalent is the dollar amount
that – if the consumer received it with certainty – would also yield her 12.502 in utility. So we are
looking for a level of w = CE such that ln(CE) = 12.502. That level of wealth is $268,787.54.

The risk premium is the EV of the gamble minus the certainty equivalent. The EV of this gamble is
$280,000, so the risk premium = EV – CE = $280,000 - $268,787.54 = $11,212,46.

Now suppose that this consumer can purchase as much or as little insurance as she wishes at a per
dollar premium of $0.20.

b. Draw a diagram illustrating this consumer’s insurance budget line. Write down an equation for
this budget line.
 Dr. Donna Feir
Economics 313

Note that the BL has slope (negative) 1/4, but is only defined for wB > $100k. So the equation for the
BL is wG = 325,000 - (1/4)wB, for wB ≥ 100. (How did I calculate the vertical intercept? Slope = rise
over run, remember....)

c. After this consumer maximizes her expected utility, what will be her contingent consumption
bundle?

The consumer’s expected utility function is EU = (0.1 X ln wB) + (0.9 X ln wG) so her
MRS = wG/9wB. Setting this equal to γ/(1 – γ) yields wG/9wB = . ⇒ wG = (9/4)wB.
Using this equation and the equation for the BL to solve, we have (9/4)wB = 325,000 – .wB ⇒
(10/4)wB = 325,000 ⇒ wB = 130,000 & wG = 292,500.

d. Given your answer to part b), how much insurance coverage will she purchase?

After she maximizes her expected utility, her wealth in the good state has declined from $300,000 to
$292,500, meaning she must have spent $7,500 on insurance. Given a per dollar premium of $0.20,
this means she must be buying $37,500 worth of insurance.

e. Draw a diagram illustrating your answers to parts b) and c)

Now suppose that the price of insurance rises; now each dollar’s worth of insurance costs $0.25.

f. After the consumer maximizes her expected utility, what will be her new state-contingent
consumption bundle after choosing her level of insurance coverage? How much coverage will
she buy? Draw a new diagram illustrating this new choice.

If γ = 0.25 then γ/(1 – γ) = (1/3). You should be able to show that the new equation for the BL is wG =
(1,000,000/3) – (1/3)wB, for wB > 100,000. Setting the MRS equal to γ/(1 – γ) now yields wG/9wB =
 Dr. Donna Feir
Economics 313

(1/3) ⇒wG = 3wB. Using this equation and the equation for the BL to solve, we have 3wB =
(1,000,000/3) – (1/3)wB ⇒ (10/3)wB = (1,000,000/3) ⇒wB = 100,000 & wG = 300,000. Notice that this
is actually the contingent endowment. Given the new price of insurance, this consumer maximizes
expected utility by consuming her endowment. That is, she purchases no insurance at all, as her MRS
= γ/(1 – γ) at the endowment. Note that she IS risk averse, but even given her risk preferences, the
price of insurance is simply too high, given her contingent endowment (question to think about: how
would this change if her endowment in the bad state was zero?).

To make sure you understand this, think now about what would happen now if the price of insurance
rose to say $0.40. She is already buying no insurance, and so her demand can’t decrease anymore.
Mathematically, if you set her MRS equal to γ/(1 –γ) in this case (where γ = $0.40), you would find
that her IC is tangent to the new BL at a point to the left of her endowment, which is not in the
feasible set of options, unless we allow the consumer to sell insurance. We’ll look at the selling side of
insurance soon.

8. Suppose that Joon and Yoosoon both have a good paying job that pays $ 120.000 a year to each of
them. They both have a risk of getting laid off of 5%. Yoosoon’s utility function over money is U= x ½, and
Joon’s utility function over money is U= x ¼.

a. Without risk pooling, what is the mean and the variance of the “job gamble”?

The mean and the variance of the “job gamble” that each of them faces without risk pooling are Mean
= .95*120,000+.05*0=114,000, Variance = .95*(120,000-114,000)2+.05*(0-114,000)2=684,000,000.

b. Find the expected utility of the “job gamble” for each of them without risk pooling.

Yoosoon’s expected utility of the job gamble without risk pooling is .95*120,000½+.05*0½=329.09;
Joon’s expected utility of the job gamble without risk pooling is .95*120,000¼+.05*0¼=17.681.

Suppose Joon and Yoosoon pool their risk by agreeing to split their income equally no matter what
happens.

c. With risk pooling, what is the mean and the variance of the new “job gamble”?

Here is the probability tree for risk pooling:

employed
.95*.95 = 0.9025
.95
employed
Unemployed .95*.05 = 0.0475
.95
Joon

.05
employed .05*.95 = 0.0475
Yoosoon

.95
Unemployed
Unemployed .05*.05 = .0025
.05
.05
 Dr. Donna Feir
Economics 313

Mean=.0025*0+2*0.0475*60,000+.9025*120,000=114,000

Variance=.0025*(0-114000)²+2*0.0475*(60000-114000)²+.9025*(120000-114000)²
=342,000,000

d. What is the expected utility for each of them with risk pooling?

Yoosoon’s expected utility of the job gamble with risk pooling is

.9025*120,000½+2*0.0475*60,000½+.0025*0½=335.91 (without risk pooling: 329.09)

Joon’s expected utility of the job gamble with risk pooling is

.9025*120,000¼+2*0.0475*60,000¼+.0025*0¼=18.284 (without risk pooling:17.681). Both Yoosoon and
Joon are better off with risk pooling.