Winter 2021

Microeconomics II
Uncertainty and Risk

Dr. Wided Hemissi

Exercise 1:
Imen’s income next year is uncertain: there is 60% probability she will make $22,000 and a 40%
probability she will make $35,000. The accompanying table shows some income and utility levels for
Imen.

Income ($) Total Utility (utils)

22,000 850

25,000 1,014

26,000 1,056

35,000 1,260

a. What is Imen’s expected income? Her expected utility?

b. What certain income level leaves her as well off as her uncertain income? What does this
imply about Imen’s attitudes toward risk? Explain.
c. Would Imen be willing to pay some amount of money greater than zero for an insurance policy
that guarantees her an income of $26,000? Explain.
Exercise 2
Consider an individual whose utility function is shown in the following table:

Income (in dollars) Total utility (utils) Marginal Utility

0
0
100
1000
140
2000
166
3000
185
4000
200
5000
212
6000

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1.
a. Calculate the marginal utility of income for this individual at each income level.
b. What is his attitude toward risk? Justify your answer.

2. Consider a lottery in which there are five possible payoffs: $9, $16, $25, $36, and $49, each
occurring with equal probability. Suppose that a decision maker has a utility function given by the
formula U = I where I represents income. What is the expected utility of this lottery?

3. You have a utility function given by U = 2I + 10 I where I represents income.

You are considering two job opportunities. The first pays a salary of $40,000 for sure. The other
pays a base salary of $20,000, but offers the possibility of a $40,000 bonus on top of your base
salary. You believe that there is a 0.50 probability that you will earn the bonus.
a. What is the expected salary under each offer?
b. Which offer gives you the higher expected utility?
c. Based on your answer to (a) and (b), are you risk averse? Justify your answer.

Exercise 3:
Explain how each of the following events would change the equilibrium premium and quantity of
insurance in the market, indicating any shifts in the supply and demand curves.
a. An increase in the number of ships traveling the same trade routes and so facing the same kinds
of risks
b. An increase in the number of trading routes, with the same number of ships traveling a greater
variety of routes and so facing different kinds of risk.
c. An increase in the degree of risk aversion among the shipowners in the market
d. An increase in the degree of risk aversion among the investors in the market
e. An increase in the risk affecting the economy as a whole
f. A fall in the wealth levels of investors in the market
Exercise 4:
You are considering investing some of your money in a startup company. You currently have an
income of $4,000 and you are considering investing $2,000 of that in the company. There is 0.5
probability that the company will succeed and will pay you out $8,000 (your original investment of
$2,000 plus $6,000 of the company’s profits). And there is a 0.5 probability that the company will fail
and you will get nothing (and lose your investment). The accompanying table illustrates your utility
function.
a. Calculate your marginal utility of income for each income level. Are you risk-averse?

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b. Calculate the expected value of your income if you make the investment.
c. Calculate your expected utility from making the investment.
d. What’s your utility from not making the investment? Will you therefore invest in the
company?
Income ($) Total Utility (utils)

0 0

1,000 50

2,000 85

3,000 115

4,000 140

5,000 163

6,000 183

7,000 200

8,000 215

9,000 229

10,000 241

Exercise 5:
Suppose that an investor has to choose between 2 projects A and B. Project B leads to a revenue of
$60 for sure. However, with project A, he can make $100 with a probability of 60% or earn nothing
with a probability of 40%. The utility function of the investor is the following: U(I) = I² where I stands
for the income.

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Income ($) Total Utility (utils) Marginal Utility

10

20

30

40

50

a. Fill in the table above. What can you conclude about the investor’s attitude toward risk?
b. Calculate the expected income and the expected utility for both projects.
c. Which project will the investor choose?
d. Would an investor with a utility function U(I) = I1/2 make the same choice? How can you
explain the difference?
Exercise 6: (Final Exam Spring 2019)

NOTE: PART 1 AND PART 2 ARE INDEPENDENT

PART 1:
Consider two lotteries A and B. With lottery A, there is a 0.8 probability that you receive a payoff of
$10000 and a 0.2 chance that you receive a payoff of $4000. With lottery B, you will receive a payoff
of $8800 for certain.
𝐼2
Suppose that your utility function is given by the following equation 𝑈 = where I represents the
10000
monetary payoff.
1. Calculate your expected payoff under each lottery.
2. Draw a table to calculate your utility levels and the marginal utility values associated with the
following payoff levels: $4000, $5000, $6000, $7000, $8000, $9000 and $10000.
3. Based on your answer to the previous question, are you a risk averse or a risk loving person? Justify
your answer.
4. Calculate your expected utility under each lottery. Which lottery will you choose?

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PART 2:
Your current disposable income 𝐼 (amount of money available for consumption and saving) is $90,000.
Suppose that there is a 1 percent chance that your house may burn down, and if it does, the cost of
repairing it will be $80,000, reducing your disposable income to $10,000.

Suppose, too, that your utility function is 𝑈 = √𝐼 and that you can buy an insurance policy that fully
reimburses you for your loss.
1. What is your expected utility if you do not purchase the insurance policy?
2. Suppose that the price of the insurance policy is $500. What would be the value of your disposable
income if you buy the insurance policy?
3. Calculate your expected utility from purchasing the insurance.
4. Based on you answers to the previous questions, would you buy the insurance policy? Justify your
answer.