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    Pset1 PDF

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    kkylatte

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    Pset1 PDF

    Uploaded by

    kkylatte
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    pset1.pdf

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    Pset1 PDF

    Uploaded by

    kkylatte

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    © All Rights Reserved
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    Problem Set 1

    Due date: April 26 (Wed) Midnight. 70 points total.

    Problem 1. True for False (3 points each).

    (1) Expected utility cannot account for a person choosing lotteries according to expected
    value. (T / F)

    (2) It’s possible to tell whether a person has utility u1 (x) = log x or u2 (x) = log (4x) from
    their choices. (T / F)

    (3) Suppose you choose a stock if and only if all your friends also choose that stock. Your
    choices could be incomplete. (T / F)

    (4) The reflection and isolation effects can appear in the same problem. (T / F)

    (5) Standard (i.e. non-behavioral) economics can explain why some people gamble. (T /
    F)

    1
    Problem 2. This problem takes you through the formal definition of risk aversion / risk
    loving. Given a lottery P , let E (P ) be the expected value of the lottery P . For example, if
    P = ($10, 0.5; $0, 0.5), then

    E (P ) = 0.5 ◊ 10 + 0.5 ◊ 0 = 5

    We say a person is

    • Risk averse if he chooses E (P ) dollars for sure over the lottery P

    • Risk neutral if he is indifferent between E (P ) dollars and the lottery P

    • Risk loving if he chooses the lottery P over E (P ) dollars for sure.

    One way to measure “how” risk averse someone is is to use something called the Arrow-
    Pratt coefficient of risk aversion. Given a vNM utility u, the Arrow-Pratt coefficient is

    ≠uÕÕ (x)
    r (x) =
    uÕ (x)

    (1) Ann has vNM utility u1 (x) = x, Bob has utility u2 (x) = log (2x + 1) and Carl has
    utility u3 (x) = x3 . Who is risk neutral, risk averse and risk loving? (5 points)

    (2) Consider the lottery P again. Find the dollar amount x such that each person is
    indifferent between the lottery P and $x (x is the certainty equivalent of P ) (10
    points)

    (3) Calculate the Arrow-Pratt coefficients for everyone. How do they compare? Does this
    agree with your answers before? (10 points)

    (4) Calculate the Arrow-Pratt coefficient for utility u (x) = ≠e≠flx where fl > 0. This type
    of utility is called Constant Absolute Risk Aversion (CARA). Why do you think
    it’s called CARA? (5 points)

    x1≠fl
    (5) Calculate the Arrow-Pratt coefficient for utility u (x) = 1≠fl
    where fl > 0. This type
    of utility is called Constant Relative Risk Aversion (CRRA). Why do you think
    it’s called CRRA? (5 points)

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