IDE501 Microeconomics for Development

Problem set, Oct 5

1. There are four options as the following.

Option A: Receiving 100 with certainty;
Option B: Receiving 500 with probability 0.2, receiving 100 with probability 0.79,
and receiving 0 with probability 0.01;
Option C: Receiving 100 with probability 0.21, and receiving 0 with probability 0.79;
Option D: Receiving 500 with probability 0.2, and receiving 0 with probability 0.8.
An expected utility maximizer strictly prefers A to B, then how does this person
compare C and D?

A. This person prefers C to D.

B. This person prefers D to C.
C. This person is indifferent between C and D.
D. There is no enough information to determine this.

2. For the utility function U = W a, what values of "a" correspond to being risk averse,
risk neutral, and risk loving, for an expected utility maximizer?

3. Bob's utility function is shown in the Figure below. He currently has $100 worth
of property, but there is a 50% chance that all of it will be stolen. An insurance
company offers to reimburse Bob for his loss if the money is stolen. What is the
most that Bob would pay for such a policy?
4. An expected-utility-maximizing individual has an initial wealth of $35,000 and
might incur a loss of $10,000 with probability p. Insurance is available that
charges $gK to purchase $K of coverage, meaning that the individual needs to
pay $gK to buy $K of coverage, which will reimburse him $K when the loss
occurs. What value of g will make the insurance actuarially fair? If she is risk
averse and insurance is fair, what is the optimal amount of coverage?
Note: An actuarially fair insurance will give the insurance company a zero expected
profit.