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EC3000 Sem3 (Lec5)

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32 views3 pages

EC3000 Sem3 (Lec5)

Uploaded by

ddd207x
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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EC3000 Advanced Microeconomics 2023-24

Seminar 3: Problem Set


Module leader: Guillaume Wilemme - guillaume.wilemme@leicester.ac.uk
Seminar Tutor: Mert Gumren - mg534@leicester.ac.uk
Seminars play a pivotal role in assimilating the content presented in lectures and in
achieving optimal readiness for both the midterm and final exams. Engaging in seminars
encompasses three essential actions for students:

• Preparing the problem set in the week before the seminar.

• Actively participating during the seminar sessions,

• Reviewing and repeating the seminars’ questions and exercises.

Each seminar is structured around a problem set that comprises short-essay questions,
requiring minimal mathematical manipulation, as well as numerical exercises. These
questions and exercises closely mirror the difficulty and subject matter of the midterm
and final exams. Questions marked with the symbol ♠ signify tasks that students may
choose to prioritise. Students are invited to think about the takeaway or morale of each
question and exercise.

Questions
Question 1. Explain the idea behind collateralised debt obligations in less than 100
words.

Question 2. ♠ Read the section ‘The Market for Insurance and The Poor’ (page 157) in
the article written by Banerjee and Duflo (2007).1 Comment on the following extract:
‘Poor households also bear most health-care risks (both expenditures and foregone earnings)
directly. For example, Gertler and Gruber (2002) find that in Indonesia a decline in the
health index of the head of the household is associated with a decline in non-medical
expenditures.’
Explain carefully, in less than 200 words, how we can conclude from the result of Gertler
and Gruber that households in Indonesia are not fully insured.
1
Banerjee and Duflo. ‘The Economic Lives of the Poor,’ Journal of Economic Perspectives, 2007.

1
Question 3. ♠ Dorothy is thinking about creating a business. Her returns if she creates
a business are X = 1000 with probability 0.5, or X = −100 with probability 0.5. Alter-
natively, Dorothy can be hired and get Y = 200 for sure. Her certainty equivalent of X
is 100. Is it optimal for her to create a business or not?
A bank is willing to help her. With a loan from the bank, she would not loose income
if the project fails but she would get less income if it succeeds. Her returns with the loan
are Z = 800 with probability 0.5 and Z = 0 with probability 0.5. Her certainty equivalent
of Z is 300. What is now the best option for her?
Use this example to illustrate the social benefits of insurance for production decisions.
Your answer must contain less than 300 words.

Exercises

Exercise 1 (Demand for insurance). This exercise introduces you to the optimal de-
cision regarding insurance. Depending on the price of insurance, an individual decides the
type of coverage (partial or full).

Jennifer’s preferences over wealth can be described by the utility function


√
U (x) = x.

Suppose that her entire wealth is provided by a property worth £1million. However this
property has a 10% chance of being completely destroyed by a fire. Denote X the random
value of the property.

1. Show that Jennifer is risk averse.

2. Compute the utility of the expected value and the expected utility of the property
for Jennifer. Why do they differ?

3. Suppose that a fire insurance contract is available that offers full coverage for Jen-
nifer’s property in case of accident. The insurance product costs C in total. Find the
expected utility of Jennifer when she opts for this insurance product, as a function
of C.

4. What is the maximum amount C̄ Jennifer would pay for this full insurance?

5. Suppose now that Jennifer can choose the level of coverage for her property. Care-
fully explaining your analysis, show that, if the insurance price is 15p per pound,
Jennifer would buy approximately £436,000 of coverage (£435,897). Explain why,
if the price were of 10p per pound, she would insure her property for its full value.

2
Exercise 2 (Production under uncertainty). ♠ Wallace owns a firm that sells frozen
fries. He must choose the quantity of potatoes x to buy to produce a quantity y =
√
f (x) = 2 x of fries. Wallace receives the profits π as income, which generates utility
U (π) = 100 ln(π/90). The price of potatoes is normalised to 1. The price of french fries,
however, is uncertain. With probability q = 0.25, the price will be p1 = 7 (state 1). With
probability 1 − q, the price will be p2 = 11 (state 2).

1. Show that Wallace is risk-averse. Write Wallace’s expected profits and Wallace’s
expected utility as functions of x.

2. What is the optimal quantity of potatoes Wallace would buy if he were risk-neutral,
or equivalently, if he were maximising expected profits? Show that this quantity is
xA = 100.

3. Consider another option xB = 80. Which option does Wallace prefer between xA
and xB under the utility function U ? Explain.

From now suppose Wallace can sell french fries on a futures market. The price on
this market is pF .

4. What is the price pF when the futures market is competitive?

5. Wallace decides to sell all his french fries on the futures market. Does he prefer to
buy a quantity xA or xB ? Conclude.

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