SMU Classification: Restricted

Econ219 Homework 2
Question 1.
• Consider the lottery where one wins $90 with probability 1/3 and $0
with probability 2/3. Suppose Ben’s utility function is such that
U($90)=12 and U($0)=3.
• What is the expected monetary return of this lottery?
• What is Ben’s expected utility of this lottery?
• Show in a graph the utility function of Ben for three cases (1) if he is
risk averse, (2) risk neutral, and (3) risk loving.
• Indicate in the graph the certainty equivalent of Ben in each case.
• Indicate in the graph the risk premium of Ben in each case.

Fali Huang (SMU) Econ219 OE 1

 SMU Classification: Restricted

Answer to Question 1.
• The expected monetary return of this lottery is
EM=1/3*$90+2/3*$0=$30.
• Ben’s expected utility of this lottery is
EU=1/3*U(90)+2/3*U(0)=1/3*12+2/3*3=4+2=6
• The certainty equivalent of Ben is CE defined as U(CE)=EU=6.
• The risk premium is RP=$30-CE.

Fali Huang (SMU) Econ219 OE 2

 SMU Classification: Restricted

U($30) > EU  risk-averse.

12

U($30)

EU=6

$0 CE $30 $90 Wealth

Fali Huang (SMU) Econ219 OE

3
 SMU Classification: Restricted

U($30) = EU  risk-neutrality.

12

U($30)=
EU=6
3

$0 $30=CE $90 Wealth

Fali Huang (SMU) Econ219 OE 4

 SMU Classification: Restricted

U($30) < EU  risk-loving.

12

EU=6
U($30)
3

$0 $30 CE $90 Wealth

Fali Huang (SMU) Econ219 OE 5