ECON 410: Problem Set #6

Directions:
1. This assignment is due by 11:59 pm on Wednesday, September 30.

2. Your answers must be submitted through Sakai. You can find “Problem Set #6” under Tests
& Quizzes on Sakai.

3. It is your responsibility to allow enough time before submission to safeguard against

technical glitches. Glitches can and do happen and are not valid excuses for missing a deadline!
To protect your submission, be sure to
• click save before you submit.
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• use the within-test navigation options, not your web browser’s forward and back options.
• use a computer, not a mobile device.
• use Firefox as errors have been reported with other browsers.

4. For each question, select the one best answer. Answer 8 out of 10 questions correctly to pass.
1. An individual has a vNM utility function over money of u(x) = 4x1/2, where x is final wealth.
Assume the individual currently has $9. He is offered a gamble over the final wealth levels
($1, $9, $25). The probability of having a final wealth level of $25 is 20%. The probability of
having a final wealth level of $1 is p. How low must p be in order for him to accept the lottery?
a. The individual will never select the lottery.
b. The individual will always select the lottery.
c. p < 0.20
d. p < 0.40
e. p < 0.575

(See Uncertainty Practice Problem #1.)

2. Jonathan currently has $10,000 and a lottery ticket in his possession. Jonathan is a superstitious fellow,
and he currently found a penny heads-up (which, of course, ensures him good luck). Given this positive
omen, Jonathan believes that his lottery ticket will win $10,000 with 90% probability and will not win

anything with 10% probability. Jonathan’s vNM utility over his final wealth level, x, is u(x ) = x
1/ 3
.
What is the smallest amount of money for which Jonathan would be willing to trade his lottery ticket?
Note if he is indifferent between trading his lottery ticket and not keeping his lottery ticket, then he is
willing to trade it.
a. $1212.44
b. $7290.00
c. $8281.95
d. $8787.56

(See Besanko 15.16.)

3. An individual has a vNM utility function over money of u(x ) = x 1/ 2 , where x is her change in wealth.
She can choose between the following lotteries. Which lottery will she choose?
• Lottery 1: Receive $100 with a 20% probability. Receive $9 and $1 with unknown
probabilities (but probabilities must sum to 1).
• Lottery 2: Receive $16 with a 50% probability. Receive $4 with a 50% probability.

a. She will always choose Lottery 1

b. She will always choose Lottery 2
c. She might choose Lottery 1 or Lottery 2, depending on the probabilities in Lottery 1.
d. She will always be indifferent between the lotteries.

(See Besanko 5.13 and 5.19 and Uncertainty Practice Problem #2.)

4. Jill possesses $160,000 worth of valuables. She faces a 0.02 probability of a burglary, where she would
lose jewelry worth $70,000. Her utility function is u(x) = 4x1/2, where x is final wealth. What is the most
that Jill is willing to pay for an insurance policy that fully covers against loss?
a. $0
b. $196
c. $1400
d. $1592
e. $1596

(See Besanko 15.19 and 15.20 and Uncertainty Practice Problem #3.)
5. An individual has a vNM utility function over money of u(x ) = x 1/ 2 , where x is the amount of money
won in the lottery. She faces two scenarios:

• Scenario 1: With a 50% probability she wins $36. With a 50% probability she wins $16.
• Scenario 2: With a 50% probability she wins $0. With a 50% probability she wins $x.

For what value of x will the risk premia be identical in these two scenarios?

a. 0
b. 4
c. 16
d. For no values of x can the two risk premia be identical

(See Besanko 15.14 and 15.15 and Uncertainty Practice Problems #4 and 5.)

6. A consumer purchases housing (H) and spends the remainder of income on a composite good
(OG). Her preferences over housing and the composite good are monotonic, complete, transitive
and convex. The government is considering one of two policies. Policy A taxes housing by $50
per unit consumed. With the tax in place, the consumer purchases 100 units of housing and Y
units of the composite good. Policy B collects a lump-sum tax of $5,000 from the consumer's
income. Which of the following statements is accurate? (Assume housing is a normal good.)
a. The consumer prefers Policy A to Policy B, and will consume more housing under Policy A
than Policy B.
b. The consumer prefers Policy A to Policy B, and will consume more housing under Policy B
than Policy A.
c. The consumer prefers Policy B to Policy A, and will consume more housing under Policy A
than Policy B.
d. The consumer prefers Policy B to Policy A, and will consume more housing under Policy B
than Policy A.
e. The consumer is indifferent between Policy A and Policy B, and will consume the same
amount of housing under both policies.
7. A tax cut that raises the after-tax wage rate will most likely result in more hours worked if the
substitution effect outweighs the income effect.
a. True
b. False

8. Consider a consumer who has a wage income of $120,000 in the present and expects to earn no
wage income in the future. (She plans to retire.) The interest rate between the present and the
future is 50%. Consumption in the present is a normal good. If the interest rate rises to 60% her
consumption in the present will increase if the substitution effect is smaller than the income
effect.
a. True
b. False

9. A consumer cares about dollars of consumption today and dollars of consumption next year. The
consumer is endowed with $50 today and $200 next year. The interest rate is 50%, and the MRS
at the endowment point is 1.25. This consumer will choose to be a borrower.
a. True
b. False

10. When offered a wage rate of $10 per hour, Aaron chooses to work 10 hours per day. Suppose
instead that he is offered $9 per hour for the first 8 hours and $14 per hour for any additional
hours. Assume Aaron has 24 hours available in a day to work or engage in leisure. Aaron will
choose to work more hours under the new wage structure and will be better off.
a. True
b. False