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BITS, PILANI- Hyderabad Campus
First Semester, 2023-24

BEHAVIORAL ECONOMICS: ECON F345
Assignment 1
Due Date: 04:50 PM, 06th September, 2023 Max. Marks: 15

Weightage: – %
Write your answers very clearly and neatly.
Arguments and steps should be precise and complete.
For all the questions, you need to provide the complete derivation.
You need to write your answers neatly, with proper margins. It can be either hand-
written or typed. The entire assignment should be written on homogenous sheets in a
legible manner! 2 marks are for these!
1. Consider two firms, say A and B. Suppose both of these firms produce same good, say
Q. The cost functions of these two firms are same except for the fixed cost components.
Suppose fixed cost for firm A is FA and that for firm B is FB , and FA > FB . Here
we assume that both firms are rational. What should be the relation between QA and
QB ? Explain very clearly, considering all possible cases. 1 marks
2. Suppose a box contains 20 coins- 14 of them are fair i.e. both Head (H) and Tail (T )
are equally likely, 3 of them have both sides H, and 3 of them have both sides T . A
coin is picked randomly and tossed- if its H, you get Rs. 1700; else you get 1200. You
are not allowed to inspect the coin, you can just see the outcome of tosses.
Further suppose first toss happens to be T . Now what is the maximum amount that
you will be ready to pay to play this game for the second toss (same coin)? Assume
that you are a expected utility maximiser with a risk averse attitude. 1 marks
3. Consider the lottery L = {100, 0.25; 400, 0.25; 900, 0.50}. What is the certainty equiv-
alent of this lottery if you follow the RDU principle of decision making? Assume that
1 1
the value function is v(x) = x 2 and the weight function is w(p) = p 2 . 1 marks
4. Consider following lotteries-
L1 = (Rs.5000, 0.30; Rs.1000, 0.70) L2 = (Rs.4000, 0.40; Rs.1000, 0.60)
L3 = (Rs.5000, 0.12; Rs.1000, 0.88) L4 = (Rs.4000, 0.16; Rs.1000, 0.84)
Verify that in the presence of independence axiom and reduction axiom, L1 < L2
implies L3 < L4 . Clearly write your arguements showing each steps of derivation. 1
marks
ECON F213 Assignment-1 Page 1 of 3

5. Consider the following game. A die is being tossed repeatedly. In any roll, if the
number is greater or equal to 4 (event H), you get Rs. 100; and Rs. 1000 if it’s less
than or equal to 3 (event L). Before each roll, you need to decide whether you want to
participate in the game - there is an entry fee of Rs. F. Further you believe that the
die is either fair (p = 61 for each number); or biased where getting H has p = 25 and L
has p = 53 . Suppose that to start with you believe that the coin is fair with 60 per cent
probability and unfair or biased with 40 per cent probability. You are not allowed to
verify the fairness of die, you can just see the outcome of the roll. Use the expected
value approach and Bayesian updation to answer follwoing questions. 1 mark
(a) What’s the maximum entry fee that you will be ready to pay for the 1st roll?
(b) What’s the maximum entry fee that you will be ready to pay for the 2nd roll if
the outcome of the first roll is L?
(c) What’s the maximum entry fee that you will be ready to pay for the 2nd roll if
the outcome of the first toss is H?
6. Recall the carry umbrella/don’t carry umbrella example covered in the class while
discussing maximin and minimax risk criterion. Reconstruct the example such that
both these approaches gives different optimal actions. 1 mark
7. Consider an expected utility maximiser with utility function u(w) = wa , a > 0. Verify
whether this individual always rejects the lottery {(w + 110), 0.5; (w − 100), 0.5} for all
wealth level. 1 mark
8. Consider the following game - a fair coin is tossed repeatedly in independent trials
until a head comes up. If a head comes up on the n-th toss, then the payoff from
n
this gamble is e2 . Consider an individual with utility function ln(m), where m is the
amount of money won. If this individual is an expected utility maximiser, what will
be the maximum amount that he will be willing to pay as an entry fee to play this
game? Briefly explain the result. 1 mark
9. Consider the following hypothetical facts- “Only 1 percent of people in the world are
rational. We have a test for rationality. If someone is rational, they have a 90 % chance
of passing. If someone is irrational, they have a 30 % chance of passing. Alexa has just
given the test and qualified.” Assume that Alexa was drawn randomly from the world
population. What is the probability that Alexa is truly rational? 1 mark
1
10. Consider an individual who has the following value function: v(x) = x 2 for gains and
1
v(x) = −2(|x|) 2 for losses. This individual is facing a lottery which consist of winning
Rs. 25000 with a 25 % chance, Rs. 15000 with a 25 % chance, and losing Rs. 5000
with a 50 % chance. Suppose the probability weight function is p2 . What will be the
expected utility of this lottery? What will be the value of this lottery as per the RDU
approach? What will be the certainty equivalent of this lottery as per the expected
theory approach? What will be the certainty equivalent of this lottery as per the RDU
approach? 1 marks

11. Consider two lotteries- 2 marks
L1 = {200, 0.20; 400, 0.50; 500, 0.30}
L2 = {500, 0.10; 300, 0.70; 100, 0.20}
(a) Check for first-order stochastic dominance between these lotteries.

(b) Consider an expected utility maximiser with the utility function u(x) = ln x.
Which lottery is going to be preferred? What is the risk premium (RP) of the
lottery L1 ?
(c) Consider a decision maker who follows the modified expected utility approach
(MEU). Assume the utility function to be u(x) = ln x and the probability weight
function to be
p0.50
w(p) = 0.50
{p + (1 − p)0.50 }2
Which lottery is going to be preferred?
(d) Consider a decision maker who follows the rank dependent utility approach (RDU).
Assume the utility function to be u(x) = ln x and the probability weight function
to be
p0.50
w(p) = 0.50
{p + (1 − p)0.50 }2
Which lottery is going to be preferred?
12. Consider two lotteries L1 = {2000, 1} and {2000, 0.50; 2100, 0.50}. Is it possible that
a decision maker prefers L1 to L2 if the decision maker follows (a) expected utility
approach, (b) modified expected utility approach, and (c) rank dependent utility ap-
proach? Clearly explain each case. Assume increasing utility/payoff/welfare function.
1 marks

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BITS, PILANI- Hyderabad Campus

First Semester, 2023-24

Due Date: 04:50 PM, 06th September, 2023 Max. Marks: 15

Write your answers very clearly and neatly.

Arguments and steps should be precise and complete.

4. Consider following lotteries-

L1 = (Rs.5000, 0.30; Rs.1000, 0.70) L2 = (Rs.4000, 0.40; Rs.1000, 0.60)

L3 = (Rs.5000, 0.12; Rs.1000, 0.88) L4 = (Rs.4000, 0.16; Rs.1000, 0.84)

ECON F213 Assignment-1 Page 1 of 3

ECON F213 Assignment-1 Page 2 of 3

L1 = {200, 0.20; 400, 0.50; 500, 0.30}

L2 = {500, 0.10; 300, 0.70; 100, 0.20}

(a) Check for first-order stochastic dominance between these lotteries.

ECON F213 Assignment-1 Page 3 of 3

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BITS, PILANI- Hyderabad Campus

First Semester, 2023-24

Due Date: 04:50 PM, 06th September, 2023 Max. Marks: 15

 Write your answers very clearly and neatly.

 Arguments and steps should be precise and complete.

4. Consider following lotteries-

L1 = (Rs.5000, 0.30; Rs.1000, 0.70) L2 = (Rs.4000, 0.40; Rs.1000, 0.60)

L3 = (Rs.5000, 0.12; Rs.1000, 0.88) L4 = (Rs.4000, 0.16; Rs.1000, 0.84)

ECON F213 Assignment-1 Page 1 of 3

ECON F213 Assignment-1 Page 2 of 3

L1 = {200, 0.20; 400, 0.50; 500, 0.30}

L2 = {500, 0.10; 300, 0.70; 100, 0.20}

(a) Check for first-order stochastic dominance between these lotteries.

ECON F213 Assignment-1 Page 3 of 3

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Write your answers very clearly and neatly.

Arguments and steps should be precise and complete.