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Tutorial 1 Questions

Tutorial 1 questions

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Navin Golyan
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28 views3 pages

Tutorial 1 Questions

Tutorial 1 questions

Uploaded by

Navin Golyan
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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TUTORIAL 1

1. Alice can either go to the University of Quality or Real World University, both
of which are located in her hometown. Alternatively, she can start working and
gain some working experience. She is not very sure of her ability, though. There
are two states of the world to her: that she is school smart, or that she is street
smart. Alice’s state-contingent payoffs are as follows:

School Smart Street Smart


Univ. Quality 10 2
Real World U 7 5
Work 0 8

(a) Does Alice has any (strongly or weakly) dominant choice?

(b) Does Alice has any (strongly or weakly) dominated choice(s)?

(c) Suppose Alice assigns probability 0.4 to her being School Smart, and proba-
bility 0.6 to her being Street Smart. Calculate the expected utility from each
of her choices. Which choice will she pick?

(d) In general, let p be the probability Alice assigns to her being Street Smart.
Plot the expected utility from each of her choices as a function of p in the
same graph. To help you get started, the expected utility from Univ. Quality
is given by the expression:

EU [Univ. Quality] = 2p + 10(1 − p).

Plotting it gives Figure 1. Fill in the other two lines.

(e) Using your plot in (d), argue that each of Alice’s choices can be an expected
utility maximizer for some values of p.

1
EU EU
10
UQ

p
0 1

Figure 1. Expected Utility Plot for Alice

Alice’s friend, Bob, faces the same choices as Alice. However, Bob assigns different
payoffs to attending Real World University. In particular, Bob’s state-contingent
payoffs are as follows:

School Smart Street Smart


Univ. Quality 10 2
Real World U 4 3
Work 0 8

(f) Repeat part (d) for Bob. Using your plot, argue that the choice “Real World
U” can never be an expected utility maximizer regardless of the value of p.

(g) Consider the following choice for Bob: He will flip a fair coin. If the coin
comes up head he will enrol in Univ. Quality. If the coin comes up tail he will
work. Add a row in Bob’s payoff table above for this choice. (For instance, if
he is School Smart, then with probability half he will get 10 and probability
half he will get 0. Calculate the expected payoff from this and enter in the
relevant cell.)

(h) Look at the table after you have added the new row. Does Bob has a domi-
nated strategy now?

2
2. An oil drilling company must decide whether or not to engage in a new drilling
venture before regulators pass a law that bans drilling on that site. The cost of
drilling is $1 million. The company will learn whether or not there is oil on the site
only after drilling has been completed and all drilling costs have been incurred. If
there is oil, operating profits are estimated at $4 million. If there is no oil, there
will be no future profits. The new regulation, which will pass with probability
0.5, will also introduce a 50% tax on the operating profits from drilling. Let p
denote the likelihood that drilling results in oil and assume the company has the
von Neuman Morgenstern utility function.

(a) The company estimates that p = 0.6. What are the three possible outcomes
if the oil company decides to drill and what is the probability of each one?
(b) What is the expected utility of drilling? Should the company go ahead and
drill?
(c) To be on the safe side, the company hires a specialist to come up with a more
accurate estimate of p. What is the minimum value of p for which it would
be the company’s best response to go ahead and drill?

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