Outline of A Model Essay

Explain the significance of the St. Petersburg Paradox, the Common Ratio
Effect, and simultaneous gambling and insurance, and their implications
for Expected Utility theory.

Explain what the St. Petersburg Paradox is and what it implies about the
proposition that individuals always choose between lotteries on the basis of their
expected values.

Explain in detail the relationship between the St. Petersburg paradox and
Expected Utility theory.
o Explain how the observation of the paradox led to the early formulation of
the theory.
o Show that Expected Utility theory can explain the phenomenon if the utility
function is concave but not if the utility function if convex or linear.
Comment on the implications in terms of risk aversion.

Outline the phenomenon of simultaneous gambling and insurance and the

difficulties Expected Utility theory has in explaining the phenomenon.
o Discuss the observed fact that individuals both gamble and buy insurance.
o Highlight the difficulties Expected Utility theory has in explaining the
phenomenon if the standard assumption of diminishing marginal utility is
made.

Discuss and evaluate Friedman and Savages explanation of the phenomenon.

o Discuss their justification for the particular kind of utility function assumed.
o Show explicitly that if an individuals utility function assumes a particular
shape and his/her initial wealth is at a certain point on the utility function,
then he/she will buy both lottery tickets and insurance policies.

Explain what the Common Ratio Effect is.

(Note: the Common Ratio Effect is not the same as the Allais Paradox.)

Show that Expected Utility theory cannot be made consistent with the observed
pattern whatever utility function is used.
o Show that the observed pattern always contradicts the predictions of the
theory without making any assumptions on the utility function. (You should
be able to demonstrate a contradiction without assuming, for example,
u(0)=0.)

General Comments:
When you claim something to be true, show explicitly why it is true. Discussing its intuition
or citing the source of the claim is not sufficient. For example, if you claim the expected value
of a lottery tends to infinity, show it is so explicitly and in detail.

Rough marking scheme:

An essay that addresses all the key points correctly gets a mark >=75; an essay that contains
minor mistakes or fails to address a minor point gets a mark between 60 and 75; The rest will
get 50 something or less. In particular, an essay cannot get a 75 or higher if it does not
explicitly substantiate major claims made. For example it must be demonstrated explicitly that
the Common Ratio effect contradicts the predictions of EUT whatever kind of utility function
is used: a contradiction must be demonstrated without making any additional assumption on
the VNM utility function.