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FMIC Assignment(3)

The document contains solutions to a problem set in microeconomics, focusing on topics such as risk preferences, expected utility theorem, demand for insurance, and portfolio selection. It includes specific problems related to lotteries, utility functions, and the maximization of expected utility. Key concepts discussed include risk aversion, certainty equivalence, and the formulation of investment strategies.

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7 views

FMIC Assignment(3)

The document contains solutions to a problem set in microeconomics, focusing on topics such as risk preferences, expected utility theorem, demand for insurance, and portfolio selection. It includes specific problems related to lotteries, utility functions, and the maximization of expected utility. Key concepts discussed include risk aversion, certainty equivalence, and the formulation of investment strategies.

Uploaded by

trungmaxnguyen3010
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Prof. Dr.

Ferdinand von Siemens WS 2024/2025


Zhuokun Liu

Fundamentals of Microeconomics
Problem Set 3 – Solutions

Problem 1: Lottery and risk preferences

a. State the independence axiom.

b. The Bernoulli utility function of a consumer about a (positive) monetary payment


is given by the following graph:

E[u(m)]

U(E(m))

E[m] CE 12

The consumer faces a lottery where he gets a payment of 12 with a chance of 25%
and zero otherwise.
Prof. Dr. Ferdinand von Siemens WS 2024/2025
Zhuokun Liu

i. Based on the graph you see, describe the risk preferences of the consumer. Use
the curvature of the graph in your answer.

Graph is convex => Risk loving

ii. State the expected value (E[m]) and the certainty equivalence (CE) of the lottery.
Show your work graphically in the figure above.
E[m] = 12*25% = 3

CE = 6
Prof. Dr. Ferdinand von Siemens WS 2024/2025
Zhuokun Liu

iii. State the risk premium (RP) of the lottery. Interpret the sign of the risk premium
(in one sentence).

RP = E[m] - CE = 3 - 6 = -3

Since the player is risk loving => RP is negative => Player is more willing to pay for risk rather demand a positive
compensation

c. Consider a second consumer with preferences represented by the utility function


𝑢(𝑚) = 4𝑚 . State the general formulas of the Arrow Pratt measures of (i)
absolute and (ii) relative risk aversion. State the value of the relative risk aversion
for this second consumer.
Prof. Dr. Ferdinand von Siemens WS 2024/2025
Zhuokun Liu

Problem 2: Expected utility theorem

Assume four different lotteries:

 LA: lottery that yields $3000 for sure


 LB: lottery that yields $4000 with probability 0.8, and $0 otherwise.
 LC: lottery that yields $3000 with probability 0.25, and $0 otherwise.
 LD: lottery that yields $4000 with probability 0.2, and $0 otherwise.

Many studies have shown a systematic tendency for subjects to express a strict
preference for LA over LB and for LD over LC. Show that this choice pattern violates
the expected utility hypothesis.
Prof. Dr. Ferdinand von Siemens WS 2024/2025
Zhuokun Liu

Problem 3: Demand for insurance

An expected-v.N-M-utility-maximizing decision maker is endowed with wealth w.


With probability of p the agent will suffer from a loss L. Moreover, there is a
possibility of insurance that pays a in the case of a loss. The insurance costs qa. The
Bernoulli utility function takes the form 𝑢(𝑥) = ln(𝑥) and depends on the level of
wealth that is equal to 𝑤 − 𝑞𝑎 in the "good" state and equal to 𝑤 − 𝑞𝑎 − 𝐿 + 𝑎 in
the "bad" state.

a. Formulate and solve the maximization problem of the agent.


Prof. Dr. Ferdinand von Siemens WS 2024/2025
Zhuokun Liu

b. Show that this utility specification implies constant relative risk aversion.
Prof. Dr. Ferdinand von Siemens WS 2024/2025
Zhuokun Liu

Problem 4: Portfolio selection

Consider the portfolio allocation problem faced by an investor who has initial wealth
𝑌 = 100 . The investor allocates the amount a to stocks, which provide return
𝑟 = 0.3 in a good state that occurs with probability 1/2 and return 𝑟 = 0.05 in a
bad state that occurs with probability 1/2. The investor allocates the remaining 𝑌 − 𝑎
to a risk-free bond, which provides the return 𝑟 = 0.1 in both states. The investor has
von-Neumann-Morgenstern expected utility, with Bernoulli utility function of the
logarithmic form 𝑢(𝑌) = ln(𝑌).

Formulate and solve the portfolio selection problem of the investor.

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