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EC3000 Sem1 (Lec12)

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12 views3 pages

EC3000 Sem1 (Lec12)

Uploaded by

ddd207x
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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EC3000 Advanced Microeconomics 2023-24

Seminar 1: Problem Set


Module leader: Guillaume Wilemme - [email protected]
Seminar Tutor: Mert Gumren - [email protected]

Seminars play a pivotal role in assimilating the content presented in lectures and in
achieving optimal readiness for both the midterm and final exams. Engaging in seminars
encompasses three essential actions for students:

• Preparing the problem set in the week before the seminar.

• Actively participating during the seminar sessions,

• Reviewing and repeating the seminars’ questions and exercises.

Each seminar is structured around a problem set that comprises short-essay questions,
requiring minimal mathematical manipulation, as well as numerical exercises. These
questions and exercises closely mirror the difficulty and subject matter of the midterm
and final exams. Questions marked with the symbol ♠ signify tasks that students may
choose to prioritise. Students are invited to think about the takeaway or morale of each
question and exercise.

Part A: Questions
Question 1. ♠
a) Consider a lottery ticket yielding £1,000 with probability 0.01, and 0 otherwise.
Would a risk-averse individual buy this ticket for £10?
b) Does a (rational) risk-averse individual always prefer a riskless asset over a risky
asset?

Question 2. There is no one good measure of risk. We illustrate these limitations with
two examples of measure.
Let X pays 200 with probability 0.5 and 0 with probability 0.5.
Let Y pays 230 with probability 0.4 and 10 with probability 0.6.
Compute the expectation, the payoff gap and the variance of X and Y . Conclude about

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the choice between X and Y for a risk-averse individual.
√
What would a risk-averse individual with utility function u(x) = x choose? Conclude.

Question 3. This question illustrates how risk-neutral agents can provide insurance by
buying risky assets.
Thomas’ preferences are captured by the following utility function: u(w) = 3w + 2. Why
is he risk-neutral? Show that, for any asset X, u(E[X]) = E[u(X)]. Why can we conclude
that Thomas ignores the risks and only cares about expected returns (Hint: you can
compare two assets X and Y for instance)? Does this property holds for a risk-averse
individual?

Question 4. ♠ Mo is creative. He has an idea for a start-up. He thinks he could earn


£300,000 if his project succeeds, but he would make no profits if it fails. He believes
his probability of success is 1/6. Mo has the choice between i) attempting the business
project, and ii) getting £40,000 for sure by accepting a job offer.
Mo eventually decides to build the start-up. However, it turns out that the project fails.
Suppose Mo is risk-averse, did Mo make the wrong decision?

Part B: Exercises

Exercise 1 (Decision-making under uncertainty). ♠ In experiment (C) (course-


book/slides), we saw examples where lotteries cannot be easily compared. For instance, it
can happen that one risk-averse individual prefers option A to B, and another risk-averse
individual prefers option B. In that case, we need to know more about the individual’s
preferences to predict optimal decisions. These preferences are captured by the utility
function.
Helen has a utility function U (w) = (w + 100)1/3 . For each pair of gambles below, find
the best gamble for Helen.

1. Gamble 1 offers £50 with probability 20%, and £30 with probability 80%.
Gamble 2 offers £40 with probability 90%, and £50 with probability 10%.

2. Gamble 1 offers £300 with probability 60%, nothing with probability 10%, and -£50
with probability 30%.
Gamble 2 offers £100 with probability 60%, and nothing with probability 40%.

3. The following gambles use a six-sided die (each side has the same probability).
Gamble 1 offers the monetary value of the obtained number: £10 if you obtain 1,
£20 if you obtain 2, ..., £60 if you obtain 6.
Gamble 2 offers £30 if you obtain 4, 5 or 6, and nothing if you obtain 1 ,2 and 3.

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You can repeat this exercise with U (w) = (w + 50)1/4 .

Exercise 2 (Fair Gambles). ♠ Fair gambles are lotteries that are characterised by an
expected value equal to zero; i.e. they are gambles where the expected wealth of the player
is the same whether or not she accepts the gamble. A risk-averse individual never accepts
a fair gamble. The exercise illustrates this result.
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Mark’s preferences are represented by the utility function U (y) = y 2 where y is total
wealth. Mark is offered the following bet on the toss of a coin by Amanda;

• If the coin comes up tails Amanda pays Mark £5, 000;

• If the coin comes up heads Mark pays Amanda £5, 000.

Mark’s initial capital is £10, 000 which he retains in its entirety if he does not take the
bet.

1. What is Mark’s expected utility if he accepts the bet?

2. Will he accept the bet? Explain your answer.

3. Is Mark risk-averse, risk-neutral or risk-loving? Explain your answer.

Amanda offers Mark an alternative bet whereby if the coin comes up tails Amanda gives
him £10, 000 but if the coin comes up heads Mark gives Amanda his entire £10, 000.

4. Show that Mark does not accept this bet.

Amanda offers Mark yet another alternative bet whereby Mark still loses his entire
£10, 000 if the coin comes up heads, but if the coin comes up tails Amanda pays him
£50, 000.

5. Does Mark accept this new alternative? Explain your answer.

6. Given that Mark loses his entire £10, 000 if the coin comes up heads, what is the
smallest amount that Amanda has to pay Mark in the event of tails in order to
persuade him to take the bet?

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