SMU Classification: Restricted

Question 1: When faced with uncertainty, agents make choices based on expected values.
Answer: False
When faced with risk, agents make choices based on expected utility.

Question 2: An agent with increasing marginal utility (of wealth) prefers a lottery to a sure thing.
Answer: True

Increasing marginal utility of wealth is associated with risk loving, which is to prefer a lottery to a
sure thing. Risk aversion is characterized by decreasing marginal utility of wealth.

Question 3: Consider the following two lotteries:

Lottery A flips two honest coins. For each head, it pays 10 dollars, while for each tails, it costs 10
dollars.
Lottery B flips a single honest coin. If it lands on heads, it pays 20 dollars, while if it lands on tails, it
costs 20 dollars.

If forced to choose between these two lotteries, a risk averse player would choose lottery B.

Answer: False

Option B has a higher variance: twice of option A. If V is the variance of betting 10 dollars in the
coinflip, option A has a variance of 2V while option B has a variance of 4V. Risk averse agents prefer
the option with the smaller variance, since the expected values are equal in this case.

Question 4: An agent whose utility function is given by U(w) = 10w + sqrt(w), [where w is his wealth
and sqrt(w) is the square root of w] is a risk averse agent.

Answer: True

Proper way to solve this question: take one lottery and compare the expected utility with the
expected utility of the sure thing and see which one the agent prefers. U(1) = 11. U(0) = 0, U(2) = 20
+ Sqrt(2). As Sqrt(2) < 2, this agent is risk averse.
 SMU Classification: Restricted

Question 5: Consider two lotteries, A and B. With lottery A, there is a 0.90 chance that you receive a
payoff of $0 and a 0.10 chance that you receive a payoff of $400. With lottery B, there is a 0.50
chance that you receive a payoff of $30 and a 0.50 chance that you receive a payoff of $50. Suppose
that your utility function is U = √ I. The risk premium of lottery A is 57 times bigger than the risk
premium of lottery B.

Answer: False

If your utility function were , then the risk premium associated with Lottery A would
be

The risk premium associated with Lottery B would be

Lottery A has a risk premium of 36 and Lottery B has a risk premium of 0.64.

36/ 0.64 = 56.25

 SMU Classification: Restricted

Question 6: Suppose you are a risk-averse decision maker with a utility function given by U(I) = 1 –
10I-2, where I denotes your monetary payoff from an investment in thousands. You are considering
an investment that will give you a payoff of $10,000 (thus, I = 10) with probability 0.6 and a payoff of
$5,000 (I = 5) with probability 0.4. It will cost you $8,000 to make the investment. Under these
conditions, you will make the investment.

Answer: False

If you do not make the investment, your utility is:

1 – 10(8)-2 = 0.84375 (higher than investing)

If you make the investment, your utility is:

(0.6)(1 – 10(10)-2) + (0.4)(1-10(5)-2)

= (0.6)(0.9) + (0.4)(0.6)
= 0.78

Since the expected utility from the investment is less than the utility from not making the
investment, you should not make the investment.

Question 7: Consider a household that possesses $100,000 worth of valuables (computers, stereo
equipment, jewellery, and so forth). This household faces a 0.10 probability of a burglary. If a
burglary were to occur, the household would have to spend $20,000 to replace the stolen items.
Suppose it can buy an insurance policy for $500 that would fully reimburse it for the amount of the
loss. Under these conditions, the household should buy the insurance.  no utility function so you
compare EV of both scenarios

Answer: True
If you remain uninsured, you face a lottery in which you have 10% chance of $80,000 in
valuables and a 90% chance of $100,000 in valuables. The expected value of valuables is
thus $98,000.
If you purchase the insurance policy for $500, then with no burglary you have
and with a burglary you have
. The expected value if you purchase the policy is
therefore $99,500.
Since the expected value at year end with insurance exceeds the expected value at year end without
insurance, you should purchase the insurance policy for $500.
 SMU Classification: Restricted

Question 8: You are a risk-averse decision maker with a utility function U(I) = 1-3200I -2, where I
denotes your income expressed in thousands. Your income is $100,000 (thus, I =100). However,
there is a 0.2 chance that you will have an accident that results in a loss of $20,000. Now, suppose
you have the opportunity to purchase an insurance policy that fully insures you against this loss (i.e.,
that pays you $20,000 in the event that you incur the loss). If the insurance costs $5.20, you will buy
the insurance.  has utility function = determining whether this is a fairly priced insurance policy
aka EU (not buying) = EU (buying)
Answer: False
If you do not buy insurance, your expected utility is:

0.2[1 – 3200(100 – 20)-2] + 0.8[1 – 3200(100)-2] = (0.2)(0.5) + (0.68)(0.5) = 0.644

If you do buy insurance at price P, you have no risk and your utility is 1 – 3200(100 – P)-2

The most you would be willing to pay for insurance would be just a shade less than the P that makes
your utility with insurance equal to your expected utility with no insurance.

In terms of equations:

1 – 3200(100 – P)-2 = 0.644

3200(100 – P)-2 = 0.356

(100 – P)-2 = 0.356/3200

(100 – P)2 = 3200/0.356

100 – P = [3200/0.356](1/2)

100 – P = 94.81

P = 5.19.

Thus, the most that you would be willing to pay for the insurance, would be a shade less than $5.19
per thousand dollars of coverage.
 SMU Classification: Restricted

Question 9 and 10 are related.

Question 9: A firm is considering launching a new product. Launching the product will require an
investment of $10 million (including marketing expenses and the costs of new facilities). The launch
is risky because demand could either turn out to be low or high. If the firm does not launch the
product, its payoff is 0.
Here are its possible payoffs if it launches the product:
Demand is High (happens with prob. 0.5) -- 20 million in profits.
Demand is Low (happens with prob 0.5) -- 10 million in losses.
Assuming that the firm acts as a risk neutral decision maker, it should launch the new product.
Answer: True
Expected utility of launching the product is equal to the expected value for a risk-neutral firm. Thus,
this is equal to 20*0.5 – 10*0.5 = 5. On the other hand, the expected utility of not launching the
product is equal to 0. Thus, launching the product is the better option.

Question 10: In the previous problem, the value of perfect information for the firm is 5 million
dollars.
Answer: True
With perfect knowledge, if the demand is high, the expected payoff of launching the product is 20,
while the expected payoff of not launching is 0. Thus, if the demand is high, the firm will choose to
launch the product and get a payoff of 20.

On the other hand, if the demand is low, the expected payoff of launching is -10, while the payoff of
not launching is 0. Thus, if the demand is low, the firm will not choose to launch the product and get
a payoff of 0.

As each scenario happens with probability 0.5, the final expected payoff of this game is 0.5*20 +
0.5*0 = 10. Since this represents an increase of 5 over the payoff of the previous game, the value of
the information in this game is 5.