HOMEWORK 3 SOLUTIONS

Problem 1
Arnab is a risk-averse decision maker whose utility function is given by U(I ) = √I , where I
denotes Arnab’s monetary payoff from an investment. Arnab is considering an investment in
machine tools factory with a payoff of Rs. 10,00,000 with probability 0.6, and Rs. 250,000 with
probability 0.4. If the cost of the investment is Rs. 6,00,000, should Arnab invest in this factory?
Expected utility (investment) =
0.6 * √1000000 + 0.4 * √250000 - √600000 = 0.6 *1000 + 0.4*500 - 775 = 25
which is positive. Therefore, invest.

Problem 2
Consider two farmers and two pieces of land.1 We want to know what the effect is of each
farmer working his own piece of land versus the farmers cooperating and jointly working on the
two pieces of land. To simplify the exposition, we will denote these as ‘independent farmers’ and
‘cooperative farmers’ respectively.

Assume that each farmer (whether independent or cooperative) can decide on his own how much
time to spend on farming. Let farmer i’s weekly time spent on farming be denoted hi (in hours
per week; so h1 for farmer 1 and h2 for farmer 2). The farmer’s productivity (expressed in
bushels of grain) is directly proportional to the time he spends on farming. In particular, an
independent farmer produces (80*hi) bushels of grain if he works hi hours per week. Farmers in a
cooperative are more productive since they can specialize: a cooperative farmer produces (90*
hi) bushels of grain if he works hi hours per week. Cooperative farmers share the output of their
farm equally. Let bi be the bushels of grain that farmer i can take home at the end of the year,
then bi = 80hi for an independent farmer, while bi = (90h1 + 90h2)/2 for a cooperative farmer.

Farmers dislike working and more so as they work more. In partiscular, farmer i’s utility is
Ui = bi – (hi2/2)
We assume that a farmer i will choose hi to maximize his utility Ui.

(a) Write out the utility functions of an independent farmer and a cooperative farmer completely
in terms of h1 and h2.
The utility of an independent farmer is
Ui = 80hi – (hi2/2)
while that of a cooperative farmer is
Ui = 90(h1+ h2)/2 – (hi2/2)

(b) How many hours will an independent farmer work (assuming that farmers choose hi to
maximize their utility)? What is his utility?
Taking the derivative of the independent farmer’s utility with respect to hours of work and
setting it equal to zero yields:
80 – hi = 0
=> hi = 80
The utility of an independent farmer is 3200.

(c) How many hours will a cooperative farmer work? What is his utility?
1
This question is from Berndt, Chapman, Doyle and Stoker’s course at MIT Sloan
Consider farmer 1, with utility: u1 = 45(h1+h2)- h12/2
Taking the derivative of his utility with respect to his hours of work and setting it equal to
zero yields 45=h1. u1 = 45(45+45)-2025/2 = 3037.5
By symmetry, the same result holds for farmer 2.

(d) What is the problem with a cooperative farm? What would happen (qualitatively) if 100
farmers worked jointly in a cooperative farm? How could the farmers solve that problem?
The problem of the cooperative farm is that the output is common property, so farmers get
only part of the output they produce. The incentives to work change from MR=MC to a
fraction of MR = MC. Compare, in particular, independent and cooperative farmers who
consider the gain from putting in one more hour after they have already worked 45 hours.
The cost to each of working the 46th hour is 462/2 – 452/2 = 45.5

The gain for an independent worker is 80, which outweighs the cost of 45.5. For a
cooperative worker, the gain is only 45 (since half of his output goes to the other farmer), so
working the extra hour is not worth it. Note that farmer 1 putting in more hours does not
change how many hours farmer 2 works. This problem is magnified with more farmers, as
the share of the marginal bundle kept by the farmer (1/no. of farmers) decreases with the
number of farmers.

Of the number of hours that someone works is observable, the farmers could write a contract
that exploits the gains from specialization and maximizes utility. (The optimal number of
hours for each farmer is 90 per week in the cooperative and farmers would get utility of
4050.) If effort is not observable, we would have to explore incentive schemes or screening
mechanisms to align incentives.

Problem 3
An annuity provides insurance against out-living one’s financial resources. LEICO, a life
insurance company, takes a deposit from customers at age 60 years, and returns an annual
payment of Rs. 5000 till their death.
(a) Calculate the break-even deposit for LEICO if average population-wide life expectancy is 80
years. Assume a 5% interest rate.
Rs. 62311 is the deposit.
(b) If potential customers have a sense of their life expectancy, based on factors such as the
longevity of their parents, who will purchase the annuity with the deposit you have calculated
above?
Customers who expect to live for a long time, in particular, for those whose life expectancy is
greater than 80 years.
(c) If life expectancy is uniformly distributed in the population (up to a maximum of 100 years),
what is the deposit that that LEICO will ultimately end up charging? Who will finally buy
this annuity?
Only those who live for 100 years will end up buying the annuity. LEICO will charge then
85795 which is the break even value for those customers.