Economics 301 - Homework 5

Fall 2006
Dickert-Conlin / Conlin

Answer Key

U, E(U)

1. Suppose Cush Bring-it-Home Cash has a utility function of U = M2, where M is her income. Suppose Cushs
income is $8 and she is offered a bet from a fair six-sided die: If she rolls a 1, she wins $4 and if she rolls anything
else (a 2, 3, 4, 5, or 6), she loses $2.
a. Graph Cushs utility function,
150
U = M2 and label it U. This
140
represents Cushs utility if her
income is certain.
130
b. What is Cushs expected
INCOME [E(M)] if she takes
the gamble? Label this on the
x-axis.
E(M) = 1/6 * (8+4) + 5/6 * (8-2)
= 1/6 * (12) + 5/6 (6) = 2+5 =7
c. If Cush accepts the bet, what is
her expected utility E(U) from
the gamble? Draw the E(U)
chord on the graph and label
the E(U) that you calculate on
the y-axis.
EU gamble = 1/6 * (8+4)2 + 5/6 *
(8-2)2 = 1/6 (12)2 + 5/6 * (6)2 = 1/6
* 144 + 5/6 * 36 = 24 + 30 = 54

120
110
100
90
80
Uno gamble
70=64
60
EUgamble50
=54
40
30
20
10
0
0

E(U)

U=M

M loses

5
6
7
7=E(M) gamble

8
9
10
8=M no gamble

11

12 13
M wins
M, E(M)

d. If Cush turns down the bet, what is her utility with this certain income? Label this on the y-axis.
EU no gamble = (8)2 = 64
e. Does Cush take the bet? Why or why not?
No, she doesnt take the bet because EU gamble < EU no gamble, 54 < 64
f. Is this a fair gamble? Explain.
No because her expected income with the gamble ($7) is less than her expected income without the gamble ($8).
g. Does Cush take the bet if the bet changes so that if she rolls a 1 or a 2, she wins $4 and if she rolls anything else
(a 3, 4, 5, or 6), she loses $2?
Yes, because EU gamble new = 2/6 * (12)2 + 4/6 * (6)2 = 1/3 * 144 + 2/3 * 36 = 48 + 24 = 72 > EU no gamble
= 64. Think about what this would do to your diagram...
h. Is Cush risk averse, risk seeking or risk neutral? How do you know? BE EXPLICIT!
Cush is risk seeking because she has increasing marginal utility.
M
U
MU
0
0
(1-0)/(1-0)=1
1
1
(4-1)/(2-1)=3
2
4
i. True or false and explain: Risk seeking individuals accept all bets.
False, Cush is a risk seeker and turned down the first bet because the expected winnings were too small. The
probability of winning was too low and/or the payoff from winning was too small.
1

hurt

M , E(M ) E(M ) football play er

16000

14000

12000

10000

8000

6000

4000

2000

2. Suppose Dan is a National Football League (NFL) player with a utility function of U = M , where M represents
monthly income in dollars.
a. Is Dan risk averse, risk seeking or risk
U, E(U)
140
neutral? How do you know? BE
U = sqrt(M )
EXPLICIT!
Dan is risk averse because he has
120
E(U) football play er=
diminishing marginal utility. The chance
of losing of $1000 outweighs the chance
100
of winning $1000. You should be able to
Ucom mentator
show this in a variety of ways.
80
For example: Dans first $1 increases
E(U)
his utility by 1 (MU=1) and the 2nd $1
60
he receives only increases his utility by
0.41.
Suppose Dan has two job offers. The first is
40
an offer to be an NFL quarterback. With
this job there is a 0.5 probability of earning
20
$16,900/month (if he starts every game),
and a 0.5 probability of earning $4,900 (if
0
he gets hurt and sits on the bench all year).
What is Dans expected INCOME, E(M), if
he takes this new job?
M comm entator
M starts

EV(M)=1/2*(16900)+1/2*(4900) =8450+2450=10900
c. Although his expected income is __10900______, his actual income if he takes this new job will be either
__16900_________ or ____4900____________. (This may seem simple, Im just being thorough).
d. What is Dans expected utility, E(U), if he takes this quarterbacking job?
EU quarterback = * 16900 + * 4900 = * 130 + * 70 = 100
f. As an alternative, Dan has been offered a job as a TV commentator. This job offers him an income of
$10,000/month and he can earn that income next year with certainty. What is Dans utility, U, if he takes this
job?
Ucommentator= 10000 = 100
g. Which job should Dan take? Explain.
Dan is indifferent between taking the job or not taking the job since the expected utility from taking the job, 100,
is the same as the expected utility from not taking the job, 100.
h. Graph Dans utility ( U = M ) with certain income and expected utility (the chord). Also label his expected
income and certain income on the x-axis and his expected utility and certain utility on the y-axis.
i. Let t be the probability that he becomes a starter on the team and (1-t) be the probability that he sits on the bench.
What is the minimum t can be so that Dan should take the quarterbacking job? Hint: Set up an equation with t
and (1-t) in it.
He will take the quarterbacking job if:
EU quarterbacking job > EU commentator job and we know from above that EU commentator job is 100
EU quarterbacking job = t* 16900 + (1-t) * 4900 > EU commentator job =100
t* 130 + (1-t) * 70 = 100
130t + 70-70t >100
60t > 30
t > 30/60 = 0.5
In words, if the probability of becoming a starter is greater than 50 percent, he will leave his old job and take his
new job. Actually, we knew this from parts d and e.

3. Suppose that everybody in Bedrock has a utility function given by U = M . Everyone normally has an income
of $10,000, but if they get into a car accident their net income, after accident expenses, falls to $400. Half of the
drivers in Bedrock are good drivers and have a probability of 0.25 of having an accident. The other half are
bad drivers and have a probability of 0.75 of having an accident.
a. Suppose that Bedrock residents have access to insurance and can pay $p for insurance that would cover their
losses in the event of an accident. That is, they can have income of $10,000-p whether or not they are in an
accident. What is the most good drivers would be willing to pay for this insurance?
EU uninsured = 0.75 * 10000 + 0.25 * 400 = 80

b.

c.

d.

e.

Willing to pay so that their certain income gives them the same amount of satisfaction as their uncertain
income:
EU uninsured = 80 = 10000 P
6400=10000-P
P = $3600=willing to pay for insurance
How much would the bad drivers be willing to pay?
EU uninsured = 0.25 * 10000 + 0.75 * 400 = 40
Willing to pay so that their certain income gives them the same amount of satisfaction as their uncertain
income:
EU uninsured = 40 = 10000 P
1,600=10000-P
P = $8400 = willing to pay for insurance
Rubbles Auto Insurance Company is unable to distinguish good drivers from bad drivers and, therefore, must
charge the same premium to everybody. What is the expected value of claims/payouts? (Hint: consider the
probability of each type of driver and the probability that each type of driver is in an accident. Also consider
how much Rubbles has to pay if there is an accident).
If there is an accident, the insurance company the claim will be for $10000-$400=$9600. 50 percent of
the drivers are good drivers and there is a .25 chance that they are in an accident. 50 percent of the
drivers are bad and there is a 0.50 chance that they are in an accident. The expected claim is therefore:
0.50*(0.25)*9600+(0.5)*(0.75)*9600=$4,800
If Rubbles Auto Insurance Company sets its premium (p) equal to the expected value of claims you found
above, will all Bloom County drivers be willing to pay this premium?
The good drivers wont buy auto insurance from Rubbles because they are only willing to pay $3,600.
What is likely to happen in this insurance market and why? Is your answer an explanation for why the
government might make car insurance mandatory?
Only bad drivers will purchase insurance, which will cause the premium the insurance company charges
to rise to $7,200 (where did this number come from?). ADVERSE SELECTION!

f. Can you suggest ways the drivers might change their behavior once they have car insurance? They might drive
more recklessly or they might not lock their car all the time. This is called moral hazard.

4. Sperry Speculator has an investment opportunity that pays 33 with probability and loses 30 with probability .
a. If his current wealth is M=111, and his utility function is U = M , will he make this investment?
EU no investment = 111 = 10.536
EU investment = * 111 + 33 + * 111 30 = 6+4.5 = 10.5
EU no investment > EU investment
Therefore, he will not make the investment.
b. Would Wild Wanda, who is a risk seeker, be more or less likely to make this investment than Sperry. No math
please, just use intuition.
Wild Wanda is more likely to make this investment than Sperry because she loves the possibility that she might
win the 33. She loves winning more than she hates losing.. Her marginal utility is increasing with income.
c. Would Plain Jane, who is risk neutral, be more or less likely to make this investment than Sperry. Again, no
math please, just intuition (although it is easy to know by looking at the numbers what Jane would do).
Plain Jane is more likely to make this investment than Sperry because she doesnt hate losing as much as Sperry.
Her marginal utility is constant with income.
d. Would Sperry make the investment in part a if he has two equal partners (suppose Wanda and Jane invest with
him)? In this case, the gains or losses are split equally among the three partners.
EU no investment = 111 = 10.536
EU investment = * 111 + 11 + * 111 10 = 10.55
EU no investment < EU investment
Therefore, he will make the investment.
e. What is the advantage of pooling risk, as in part d?
It shares risk among people and increases the expected utility from making the investment.
5. Ross has $10,000 in income and a U = M is his utility function. His sister Monica offers him a bet where if
the fair coin comes up tails, he loses his entire $10,000. What is the minimum amount that she would have to offer
him in the event of heads to make the bet a good one for him? Set up an equation. On one side, you want the level
of satisfaction that Ross receives if he doesnt bet. On the other side, you want the expression for his expected
utility that incorporates his utility if tails comes up and his utility when heads comes up and he has $10,000+X in
income. Solve for X.
EU no gamble = 10000 = 100
M if he wins = 10000+X. M if he loses = 0
EU gamblet = * 0 + * 10000 + X = 10000 + X
Ross takes the bet if: EU no gamble EU gamble
100 10000 + X
multiply both sides by 2: 200 10000 + X
Square both sides: 40000 10000+X
Subtract 10,000 from both sides: 30000 X
That is, if Monica pays Ross at least 30,000 when the coin comes up heads, he will take the gamble.
6. Problem # 1 of your text book (The question about messy rooms). .
Best estimate is expected value of all rooms that are not shown: 90
This is likely to be unstable because all persons w/ rooms less messy than 90 (like 81-89) will not want outsiders
assuming they are this messy.
We can conclude that these persons are really messy or that it is costly in some other way to show their room.
4

7. Consider the market for houses. Suppose two different types of houses exist. Type S is a structural sound house
and Type F is a structurally flawed house. There are sixty Type S houses and forty Type F houses. All owners of
the structurally sound houses have reservation value $175,000 and all owners of the structurally flawed houses have
reservation value $75,000. (Therefore, the owners of the structurally sound houses are not willing to sell their house
for a price less than $175,000 and the owners of the structurally flawed houses are not willing to sell their house for
a price less than $75,000.)
All potential buyers are willing to pay $200,000 for a structural sound house and $100,000 for a structural flawed
house. Assume there are thousands of risk-neutral potential buyers and buyers cannot differentiate between a
structurally sound and a structurally flawed house.
a. Graphically, depict the supply and demand curves for housing. How many houses are sold in equilibrium and at
what price are the houses sold for?

S
$175,000
$100,000

D
$75,000

Q
40

100

At a price above $175,000, risk-neutral buyers know that both types of houses will be put on the market so they are
willing to pay 100,000(40/100)+200,000(60/100)=160,000. Therefore, the quantity demanded at a price above
$175,000 is zero.
At a price between $75,000 and $175,000, buyers are willing to pay $100,000 because they know only structurally flawed
houses are being put on the market. Therefore, the quantity demanded at a price above $100,000 is zero, at a price
of $100,000 is (0,infinity) and at a price less than $100,000 is infinity. The demand curve is depicted above.
Only structurally flawed houses are sold and the price of these houses is $100,000.

b. If the buyers were risk-averse instead of risk-neutral, how would this affect the supply of and demand for houses?
Depict on the graph.
It would not affect the supply and demand depicted above. The reason is that in the equilibrium above, the
buyers know they are buying a flawed house and, therefore, do not incur any risk.
c. Suppose the government is considering passing a law that requires the sellers to disclose whether their house is
structurally sound or structurally flawed. (There is actually this type of disclosure law.) Surplus is the
difference between what people are willing to pay and what they have to pay (the actual price). How much
would total surplus increase if this law were passed? Explain.
With the law, the structurally sound houses would be sold and total surplus would be increased by 60(200,000175,000)=1,500,000.