Practice Problems Week 13 Solutions. Microeconomics. Econ 300.

Professor
Singh.

1) John has a concave utility function of U(W) = W0.5. His only asset is
shares in an Internet start-up company. Tomorrow he will learn the
stock’s value. He believes that it is worth $144 with probability 2/3
and $225 with probability 1/3. What is his expected utility? What risk
premium would he pay to avoid bearing the risk?

John’s expected wealth is EW = (2/3 * $144) + (1/3 * $225) = $96 + $75 =

$171. His expected utility is EU = (2/3 * U(144)) + (1/3*U(225)) = (2/3*12)
+ (1/3*15) = 13. He would pay up to an amount P to avoid bearing the risk,
where U(EW – P) = U(171 – P) = √(171 – P) = 13 = EU. Squaring both sides
we find (171 – P) = 169, so P = 2. So John would accept an offer today for
his stock today of $169 or more, which reflects a risk premium of $2.

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2) Jacob’s utility function is U(W) = W0.33, where W is wealth. Is he risk
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averse? Jacob has an initial wealth of $27,000. How much of a risk
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premium would he require to participate in a gamble that has 50%
probability of raising his wealth to $29,791 and a 50% probability of
lowering his wealth to $24,389?
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Yes, Jacob is risk averse because he has a declining marginal utility of

wealth (MUW = 1/3W-2/3). The risk premium is the amount that a risk-
averse person would pay to avoid taking a risk. The expected value of the
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gamble is EV = 0.5*29,791 + 0.5*24389 = $27,091. Jacob’s expected utility

from the gamble is EU = 0.5*29,7911/3 + 0.5*24,3891/3 = 30. Note that this
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is equal to his original utility of wealth (27,0001/3 = 30), so he is indifferent

between the gamble and his initial wealth level. As such, we know his
required risk premium is EV - $27,000 = $27,091 - $27,000 = $91.
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3) Jamie just inherited a vineyard from a distant relative. In good years

(when there is no rain or frost during harvest season), she earns
$100,000 from the sale of grapes from the vineyard. If the weather is
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poor, she loses $20,000. Jamie’s estimate of the probability of good

weather is 60%.
a. Calculate the expected value and the variance of Jamie’s income
from the vineyard.

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 EV = 0.6*$100,000 + 0.4*(-$20,000) = $52,000. Var = 0.6*(100,000 –
52,000)2 + 0.4*(-20,000 – 52,000)2 = 3,456,000,000.

b. Jamie is risk averse. James, a grape buyer, offers Jamie a

guaranteed payment of $70,000 each year in exchange for her
entire harvest. Will Jamie accept this offer? Explain.

Yes, she would accept the offer because the expected value of the harvest
($52,000) is below that of the sure thing offer of $70,000.

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c. Why might James make such an offer?

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James may have a different idea of the probabilities of good weather and
bad weather. If he believes the chance of good weather is 90%, he is making

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a good investment from his perspective. It is also possible that he is risk-
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loving. If his expected utility from the harvest is greater than his utility of
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$70,000 with certainty, he will make the purchase. See the figure below.
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4) Suppose that Anna’s utility function with respect to wealth is U(W) =

100 + 100W – W2. Show that for W < 10, Anna’s Arrow-Pratt risk-
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aversion measure increases with her wealth.

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5) Greg and Bob are neighbors. Each owns a car valued at $10,000.
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Neither has comprehensive insurance (which covers losses due to

theft). Greg’s wealth, including the value of his car is $80,000. Bob’s
wealth, including the value of his car is $20,000. Greg and Bob have
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identical utility of wealth functions U(W) = W0.4. Greg and Bob can
park their cars on the street or rent space in a garage. In their
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neighborhood, there is a 50% probability that a street-parked car will

be stolen during the year. A garage-parked car will not be stolen.
a. What is the largest amount that Greg is willing to pay to park
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his car in the garage? What is the maximum amount that Bob is
willing to pay?

EUGreg = 0.5(80,000 – 10,000)0.4 + 0.5*80,0000.4 = 89.08. EUBob = 0.5(20,000

– 10,000)0.4 + 0.5*10,0000.4 = 46.17. Let pg be the largest amount Greg is
willing to pay and pb be the largest amount Bob is willing to pay, then:

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 u(80,000 – pg) = EUGreg = 89.08 -> pc = 5100.11 and u(20,000 – pb) = EUBob
= 46.17 -> pb = 5515.13

b. Compare Greg’s willingness-to-pay to Bob’s. Why do they differ?

Include a comparison of their Arrow-Pratt measure of risk
aversion.

Note that pg < pb because Bob is more risk-averse than Greg. The Arrow-
Pratt measure of risk aversion at any wealth level W is:

which is a decreasing function of the wealth level W.

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