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Choice Under Uncertainty: Notation

The document is a problem set for a Microeconomics II course at LMU München for the Summer Term 2024. It includes exercises on choice under uncertainty, compound lotteries, continuous distribution, linear transformation, and additional exercises related to skiing vacations and monetary payments. Each exercise requires calculations of expected value, variance, and expected utility based on different scenarios and lotteries.

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leblebi980
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9 views3 pages

Choice Under Uncertainty: Notation

The document is a problem set for a Microeconomics II course at LMU München for the Summer Term 2024. It includes exercises on choice under uncertainty, compound lotteries, continuous distribution, linear transformation, and additional exercises related to skiing vacations and monetary payments. Each exercise requires calculations of expected value, variance, and expected utility based on different scenarios and lotteries.

Uploaded by

leblebi980
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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B URDEA / M IRABELLA / P OPOVA S UMMER T ERM 2024, LMU M ÜNCHEN

M ICROECONOMICS II
P ROBLEM S ET 1

Choice under uncertainty


Exercise 1: (Notation)

a) Emil can decide whether to participate in a roulette game or not. If he plays rou-
1
lette, he wins 3500 Euro with probability 37 and loses 100 Euro with the opposite
probability. If Emil does not participate in the game, he gets 0 euros with certain-
ty. What is the outcome set X and between which lotteries L R and L¬ R does Emil
choose?

b) Esmeralda has to decide whether she will prepare for the Micro exam next wee-
kend or rather go sailing. If she prepares thoroughly, she will pass the exam with
90% probability. Regardless of the exam outcome, she consumes ‘a weekend of
hard work’ in this case. If she goes sailing, she consumes a nice weekend of sai-
ling, but passes the exam with only 30% probability. What is the set of possible
outcomes? Between which lotteries, LS and L L does Esmeralda choose?

c) Let everything be as in part b), except that the utility from sailing is uncertain.
Assume that with probability 50% there is wind and with probability 50% there is
no wind. Sailing is clearly more fun for Esmeralda when there is wind than when
there is no wind. What is the set of possible outcomes? Represent the composite
lottery ‘sailing’ graphically and formally. What simple lottery results when the
composite lottery is reduced?

Exercise 2: (Compound lotteries)


Consider the following three lotteries over monetary payments: L = ( 21 ◦ L A , 12 ◦ L B ),
L A = ( 31 ◦ 0, 32 ◦ 10) and L B = ( 23 ◦ 10, 13 ◦ 20).

a) Sketch the lottery L. Which simple lottery L̃ is equivalent to L?

b) Calculate the expected value and variance of L̃.

c) What expected utility does an individual with Bernoulli utility function u( x ) =


√
x derive from the lottery L̃? Assume that the individual has no initial wealth.

1
Micro II, Winter Term 2023/2024 Problem Set 1 LMU München

Now consider the lottery L̂ = ( 25 ◦ 0, 35 ◦ 20).

d) Calculate the expected value and variance of L̂ and compare the values with those
from b). Which lottery would you prefer, L̃ or L̂?

e) What expected utility does an individual with Bernoulli utility function u( x ) =


√
x derive from the lottery L̂? Assume again that the individual has no initial
wealth.

Exercise 3: (Continuous distribution)


Given a lottery in which one can win any amount x ∈ [0, 100]. Assume that the prize
is distributed according to the density function f ( x ) = 1/100. Let Fabian, who has
no wealth, be an expected utility maximizer with Bernoulli utility function u( x ) =
100x − 21 x2 .

a) Calculate the expected value and variance of the lottery.

b) Calculate the expected utility of Fabian.

Exercise 4: (Linear transformation)


Let ⪰U and ⪰V be two preference relations satisfying the expected utility theorem.
The Bernoulli utility functions associated with the preference relations are u and v,
with v( x ) = α + βu( x ) and β > 0. Given two lotteries L A and L B over the outcome
space X = { x1 , . . . , xn }, where piJ denotes the probability with which event xi occurs
under lottery L J with J = A, B. Show that L A ⪰U L B =⇒ L A ⪰V L B .

2
Micro II, Winter Term 2023/2024 Problem Set 1 LMU München

Other exercises (not discussed in the classes)

Exercise 5∗ : (Ski vacation example)


Silke (S) gets her utility from skiing t and considers the following vacation plans:

• Ski vacation in the German Alps. With probability pG there is snow and t = 100,
with 1 − pG there is no snow and t = 0.

• Ski vacation in the Austrian Alps. With probability p A there is snow and t = 100,
with 1 − p A there is no snow and t = 0.

• Ski vacation in the Swiss Alps. With probability pS there is snow and t = 100,
with 1 − pS there is no snow and t = 0.

• Apres-Ski at the Christmas market in Munich, i.e. t = 0 with certainty.

Let 0 < pG < p A < pS < 1. S is an expected utility maximizer with respect to skiing.

a) State S’ preference order over the four lotteries.

b) S plans to go on a skiing vacation in her already quite old car. With probability
qi , i = G, A, S, the car lasts until the vacation destination and with probability
1 − qi the car breaks down during the trip and t = 0 is consumed. Let 0 < qG <
qS < q A < 1. What can you say about Silke’s preferences with respect to the four
simple induced lotteries?

Exercise 6∗ : (Compound lotteries)


1 2
Consider the following three lotteries over monetary payments: L = ( 10 ◦ −100, 5 ◦
1 1 3 1 3 1
L A , 2 ◦ L B ), L A = ( 4 ◦ −100, 4 ◦ 100), and L B = ( 2 ◦ −100, 8 ◦ 50, 8 ◦ 100).

a) Sketch the lottery L. Which simple lottery L̃ is equivalent to L?

b) Calculate the expected value and variance of L̃.

c) What expected utility does an individual with Bernoulli utility function u( x ) =


√
x derive from the lottery L̃? Assume that the individual has initial wealth w =
200.

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