HOMEWORK ASSIGNMENT
Total Points: 20
Question 1.1 - Choice Under Uncertainty (4 points)
A student submitted the following solution to an expected utility problem:
Mykola has wealth of 10,000 UAH and utility function U(W) = √W. He faces a
lottery where he could lose 3,600 UAH with probability 0.4 or lose nothing with
probability 0.6. The insurance company offers full coverage for a premium of
1,500 UAH.
Student's solution:
Expected value of lottery = 0.4(-3,600) + 0.6(0) = -1,440 UAH
Without insurance: E[U] = √10,000 = 100
With insurance: U = √(10,000 - 1,500) = 92.2
Conclusion: Mykola should NOT buy insurance because 100 > 92.2
Your tasks:
a) Identify ALL errors in the student's reasoning and calculations (be specific)
b) Explain the economic intuition: WHY would a risk-averse person potentially accept
insurance that costs more than the expected loss?
c) Calculate the maximum premium Mykola would be willing to pay
Question 1.2 - Intertemporal Choice (4 points)
A classmate claims: "If the interest rate increases, savers will ALWAYS save more in
period 1 because saving becomes more attractive."
Your tasks:
a) Explain why this statement is incomplete or potentially wrong
b) Using the concepts of substitution and income effects, describe a scenario where
a saver might actually REDUCE their savings when the interest rate increases
c) What would the indifference curves need to look like for this to happen?
PART 2
Question 2.1 - Production Functions (3 points)
You are given that a firm has the following ANSWER: "The marginal rate of technical
substitution (MRTS) between capital and labor is MRTS = 2K/L"
Your task:
Design a production function Q = f(K,L) that would generate this MRTS. Show all your
work proving that your production function yields this MRTS. Is there more than one
possible answer? If yes, provide at least two different production functions.
Question 2.2 - Cost Minimization (3 points)
A firm's ANSWER to a cost minimization problem is: "The firm should hire K* = 25 units
of capital and L* = 100 units of labor."
Your task:
Working backwards, create a complete and internally consistent cost minimization
problem (specify the production function, input prices, and output level) that would
produce this answer. Verify your answer by solving the problem you created.
PART 3
Question 3.1 - Linking Uncertainty and Intertemporal Choice (3 points)
Consider two models we've studied:
Model A: A consumer choosing between certain consumption today vs. uncertain
consumption tomorrow
Model B: A consumer choosing between consumption in period 1 and period 2 with
a known interest rate
Your task:
Explain how these models differ in their treatment of the future. What happens to the
intertemporal choice model if we introduce uncertainty about future income? How would
the budget constraint change? Would the person save more or less compared to the
certain case? (Use economic reasoning, not just mathematics)
Question 3.2 - Production and Costs (3 points)
Draw (by hand or digitally) two production isoquants for output levels Q₁ and Q₂ where
Q₂ > Q₁. On the same graph, draw the isocost line that represents the minimum cost to
produce Q₁.
Your task:
a) Explain why the firm CANNOT produce Q₂ at the same level of cost
b) If input prices change (specifically, if the wage rate increases), show on your
graph what happens to the optimal input combination for producing Q₁
c) Does total cost increase? Does the firm use more or less labor? Explain the
economic intuition.
SUBMISSION REQUIREMENTS
Show all mathematical work where applicable
Explain your economic reasoning in complete sentences
For graphs/diagrams: hand-drawn is acceptable, but label all axes, curves, and
points clearly
Word limit: Maximum 1,500 words total (excluding equations)