Financial Economics – Topic 4 – Uncertainty and consumer behavior

1. There has just been a big snowstorm, so you stop at the hardware store to buy a snow shovel. You had
expected to pay $20 for the shovel—the price that the store normally charges. However, you find that
the store has suddenly raised the price to $40. Although you would expect a price increase because of
the storm, you feel that a doubling of the price is unfair and that the store is trying to take advantage
of you. Out of spite, you do not buy the shovel.

Linking above example to “Fairness” concept, draw demand curve for shovels.

2. A city is considering how much to spend to hire people to monitor its parking meters. The following
information is available to the city manager:
● Hiring each meter monitor costs $10,000 per year.
● With one monitoring person hired, the probability of a driver getting a ticket each time he or
she parks illegally is equal to 0.25.
● With two monitors, the probability of getting a ticket is 0.5; with three monitors, the probability
is 0.75; and with four, it’s equal to 1.
● With two monitors hired, the current fine for overtime parking is $20.

Assume first that all drivers are risk neutral. What parking fine would you levy, and how many
meter monitors would you hire (1, 2, 3, or 4) to achieve the current level of deterrence against illegal
parking at the minimum cost?

3. A moderately risk-averse investor has 50% of her portfolio invested in stocks and 50% in risk-free
Treasury bills. Show how each of the following events will affect the investor’s budget line and the
proportion of stocks in her portfolio:
i. The expected return on the stock market increases, but the standard deviation of the stock market
remains the same.
ii. The return on risk-free Treasury bills decreases.

4. Suppose that Sarah’s utility function is given by u( I )  10 I , where I represents annual income in
thousands of dollars.
i. If we assume that Sarah is currently earning an income of $40,000 (I = 40) and can earn
that income next year with certainty. She is offered a chance to take a new job that
offers a 0.6 probability of earning $44,000 and a 0.4 probability of earning $33,000.
Should she take the new job?
ii. Let us we assume that for some unexplained reason Sarah decided to take the offer. She
be willing to buy insurance to protect against the variable income associated with the
new job. If so, how much would she be willing to pay for that insurance? (Hint: What is
the risk premium?)
5. Draw a utility function over income u (I) that describes a man who is a risk lover when his income is
low but risk averse when his income is high. Can you explain why such a utility function might
reasonably describe a person’s preferences?

6. C and S Metal Company produces stainless steel pots and pans. C and S can pursue either of two
distribution plans for the coming year. The firm can either produce pots and pans for sale under a
discount store label or manufacture a higher quality line for specialty stores and expensive mail order
catalogs. High initial setup costs along with C and S's limited capacity make it impossible for the
firm to produce both lines. Profits under each plan depend upon the state of the economy. One of
three conditions will prevail:
growth (probability = 0.3)
normal (probability = 0.5)
recession (probability = 0.2)
The outcome under each plan for each state of the economy is given in the table below. Figures in the
table are profits measured in dollars. The probabilities for each economic condition represent crude
estimates.
Economic Condition Discount Line Specialty Line
Growth 250,000 400,000
Normal 220,000 230,000
Recession 140,000 20,000

a. Calculate the expected value for each alternative.

b. Which alternative is more risky? (Calculate the standard deviation of profits for each alternative.)
c. Taking into account the importance of risk, which alternative should an investor choose?

7. Calculate the expected value of the following game. If you win the game, your wealth will increase
by 36 times your wager. If you lose, you lose your wager amount. The probability of winning is
Calculate the variance of the game.

8. Joan Summers has $100,000 to invest and is considering two alternatives. She can buy a risk free
asset that will pay 10% or she can invest in a stock that has a 0.4 chance of paying 15%, a 0.3 chance
of paying 18%, and a 0.3 chance of providing a 6% return. Joan plans to invest $70,000 in the stock
and $30,000 in the risk free asset.

a. Determine the expected percentage return on the stock and the standard deviation.
b. Calculate the weighted average return on the portfolio, given the planned investment strategy outlined
above.
c. Determine the standard deviation for the portfolio.
d. Write the equation that represents the budget line in the risk-return tradeoff. What is the slope of the
budget line? Interpret this slope.
9. Mel and Christy are co-workers with different risk attitudes. Both have investments in the stock
market and hold U.S. Treasury securities (which provide the risk free rate of return). Mel's marginal

rate of substitution of return for risk where is the

individual's portfolio rate of return and σP is the individual's portfolio risk. Christy's

Each co-worker's budget constraint is where is the

risk-free rate of return, is the stock market rate of return, and is the stock market risk. Solve

for each co-worker's optimal portfolio rate of return as a function of , and .