ECO 503 Problem Set 3
1. Consider a risk-neutral person. She must have an a!ne (linear) Bernoulli utility function u (x). That is, u (x)
must be of the form u (x) = ax + b, where a > 0 and b → R. Show that a risk-neutral person evaluates any
lottery only based on the lottery’s expected outcome. That is, for a risk-neutral person, L2 ↭ L1 if and only
if E [L2 ] ↑ E [L1 ].
2. Initially, Mobin has $9, and he is o"ered the following lottery: a six-sided fair die will be tossed once. If the
die comes up as either 2 or 3, then Mobin will win $18 and won’t have to pay anything. However, if any other
number shows up, Mobin will have to pay the $9 he has, and won’t receive any money.
(a) Is this a fair bet?
↓
(b) Suppose Mobin’s utility function over money is u (x) = x, where x is the amount of money he ends
up with. Let G be the die-tossing gamble, and let G0 be the choice of sticking with the $9 he has.
Compute Mobin’s expected utilities for both lotteries, U (G) and U (G0 ), and show that he will reject
the die-tossing gamble if he is an expected-utility maximizer.
(c) Now suppose instead of $18, in case the die comes up as 2 or 3, he will receive $w. What is the minimum
value of w for which Mobin will accept the lottery G?
↓
3. Mobin, who has utility function u (x) = x, is choosing to invest in either stock A, or stock B. Investing in
stock A will be result in a profit of either $50 or $250, with equal probability. Investing in stock B will be
result in a profit of either $100 or $200, with equal probability.
(a) Show that the expected profit of both stocks are equal.
(b) Show that Mobin strictly prefers to invest in stock B. You may assume that he starts with $0.
4. Consider an expected-utility maximizing DM, facing lotteries L1 and L2 . The lotteries are associated with
probability distributions over realizations of random variables (outcomes), picked from continuous and compact
outcome spaces. L1 assigns the uniform probability distribution over the interval [0, 1], with pdf f1 (x) = 1,
and L2 assigns a triangular distribution over [0, 1], with f2 (x) = 2x, where f2 (·) is the pdf of the distribution.
Similarly, let F1 (·) and F2 (·) denote the cdf’s associated with the L1 and L2 , respectively.
(a) Compute the two cdf’s. Observe that for all x → [0, 1], F2 (x) ↔ F1 (x)
1
(b) For each of the following utility functions, find the expected utilities of both lotteries. That is, compute
1
Eu(Li ) = u(x)fi (x)dx.
0
i. u(x) = x
ii. u(x) = x2
1
iii. u(x) = x 2
(c) For which of the utility functions does the DM prefer L2 over L1 ? Based on your answer, make an
educated guess about what property of u(·) determines the DM’s choice of L2 over L1 .
(d) Now consider an expected-utility maximizing DM, facing lottery L3 which assigns a di"erent triangular
probability distribution over the interval [0, 1], with piecewise defined cdf
1
2x2 if 0 ↔ x ↔ 2
F3 (x) =
1
4x ↗ 2x2 ↗ 1 if <x↔1
2
(e) Compute the piecewise defined pdf f3 (x).
(f) For each of the three utility functions in part (b), find the expected utility of L3 . Warning: somewhat
algebra intensive.
(g) For each of the three utility functions, rank the DM’s preferences over the three lotteries.
(h) For which of the utility functions does the DM prefer L3 over L1 ? Based on your answer, make an
educated guess about what property of u(·) determines the DM’s choice of L3 over L1 .
(w) →→
5. Remember that the Arrow-Pratt measure of absolute risk aversion is r(w) = ↗ uu→ (w) .
↓
Suppose that an individual has a Bernoulli utility function u(x) = x.
(a) Calculate her Arrow-Pratt measures of absolute risk aversion at the level of wealth w = 5.
% &
(b) Calculate her certainty equivalent for the lottery L = 16, 4; 12 , 12
% &
(c) Calculate her certainty equivalent for the lottery L→ = 36, 16; 12 , 12
6. Show that if v(x) = f (u(x)), where u, v, f are all strictly increasing, concave, and twice di"erentiable, then a
decision maker who has Bernoulli utility function v has a higher Arrow-Pratt coe!cient of risk aversion than
one who has Bernoulli utility function u.
7. (ADVANCED and OPTIONAL) Assume that in a world with uncertainty, there are two assets. The first
is a riskless asset that pays 1. The second pays amounts a and b with probabilities ω and 1 ↗ ω respectively,
where a ↘= b.
Consider a risk-averse expected-utility maximizing DM whose wealth is 1. Denote his demands for the two
2
assets by (x1 , x2 ). Assume also that the price of both assets is 1. Therefore, the DM’s budget constraint is
given by
x1 + x2 = 1; where x1 , x2 → [0, 1]
(a) Give a simple necessary condition (involving a and b only) for the demand for the riskless asset to be
strictly positive.
(b) Give a simple necessary condition (involving a,b and ω only) for the demand for the risky asset to be
strictly positive.
In the next parts, assume both of the conditions obtained in (a) and (b) are satisfied, so the DM’s
demands for both assets are strictly positive.
(c) Taking a and b as given, write down the first-order conditions for utility maximization in this asset
demand problem.
(d) Take b as given. For a < 1, show by analyzing the first-order conditions that dx1
da < 0.
(e) Which sign do you conjecture for dω ?
dx1
Give an economic explanation for your conjecture.
(f) Prove your conjecture by analyzing the first-order conditions.