Problem set 2

Microeconomics

Problem 1
Explain, in your own words, the problems highlighted in Ellsberg paradox and Allais paradox. Do a bit
of research on prospect theory and relate these to prospect theory.
(Your answer MAY NOT exceed 500 words)

Problem 2
Please solve problem 11.7 from the textbook. As you may realize it is a simple illustration of portfolio
theory made famous by Harry Markowitz

Problem 3*
This is a story in 2012:
Mr. Venkata Rami Reddy, the head of Deccan Chronicle newspaper is contemplating on selling
Deccan Chargers. Given the recent performance of the Chargers, he is worried. The team is not so
popular, but he knows some sentiment might work out. After some rigorous market survey he
realizes that he would get a payoff of Rs. 200 with probability of 0.25 and Rs. 0 with probability of
0.75. His utility is given by:
()

Here I represents his income from sale of the team. He approaches Mr. Lalith Modi whose utility
function is: ( )
. What kind of insurance mechanism can work out between Mr. Reddy and Mr.
Modi?
Problem 4
Poland wants to privatize its farming industry and therefore, will allow 10,000 farmers to produce
wheat under competitive circumstances. Entry and exit from wheat industry is relatively costless.
The cost function of a wheat farmer is:

( )

Figure out the industry supply curve

Currently, the price is given by z 20 (20 zloty, the Polish currency). What is the total production?
*

All characters in this problem are fictitious. Any resemblance in name and incidents described to real events
is purely co-incidental.

Assume that demand for wheat in the market is given by:

for some parameter values a
and b. In a carefully drawn diagram illustrate consumer and producer surplus.
All the 10,000 farmers got together and formed Polish Wheat producers Association, which started
behaving like a monopolist, in stead of competitive industry. Calculate deadweight loss.