PROBLEM SET 9.

1 – ON CHOICE UNDER UNCERTAINTY

1. Alice and Bob are sitting in a bar at 8 pm, each with Rs.100. They are both expected
utility maximizers; Alice’s Bernoulli utility function is u(z) = +√ z, and Bob’s Bernoulli
utility function is u(z) = z2. They both agree that there is a 28% probability that it will rain
within the next one hour. Consider the following bet: If it rains within the next one hour,
then Alice will give Bob her Rs.100; while if it does not rain within the next one hour, then
Bob will give Alice his Rs.100. Verify that each person will prefer to take this bet rather than
sit with his/her Rs.100.

2. Ms. A tells Mr. B and Mr. C that she believes that India will win the next Cricket World
Cup with a 70% probability. Then Mr. B offers her the bet: If India wins the Cup Mr. B will
give her Rs. 1000, but if India loses she will have to pay Rs. 2000 to Mr. B. And Mr. C offers
her the bet: If India wins the Cup Mr. C will give her Rs. 5000, but if India loses she will
have to pay Rs. 8000 to Mr. C. Ms. A is a risk-averse expected-utility-maximizer, with
Bernoulli utility function u(z) = +√ z. If she is holding Rs. 10,000, to begin with, whose bet
will she accept?

3. At 9 am on 3-8-05, Mira’s total wealth is “Rs. 90,000 in cash and a raffle ticket”. She
bought the raffle ticket on 26-7-05 by paying Rs. 750. The raffle will be played at 10 am on
3-8-05, and the winner will get a jackpot of Rs. 1,00,000. 100 tickets have been sold, and
each ticket has an equal chance of winning (one gets nothing if one does not win). Mira
believes in the “expected utility theory,” and her Bernoulli utility function is: u(z) = +√z,
where z denotes money amounts. If I want to buy Mira’s raffle ticket at 9 am on 3-8-05, what
is the minimum amount of money that I will have to pay her (rounded off to the nearest
rupee) so that she will sell me her ticket?

4. A farmer has 100 acres of land, and has to allocate his land between the production of two
crops A and B. The technology is simple − for each crop, one acre of land is used to produce
one unit of output. The market price of crop B is certain, Rs. 100 per unit. But the market
price of crop A is random − it will be either Rs.50 or Rs.200 with equal probability. The
farmer is only interested in the revenue generated from selling the crops in the market, and
has to decide on the amount of land, X acres, in which to cultivate A (with B being cultivated
in the remaining land, 100-X acres). The farmer is an “expected utility maximizer” with
Bernoulli utility function u(.).
If the farmer is “risk neutral”, i.e., u(r) = r for all positive real numbers r, what is his optimal
X? Alternatively, if he is “risk averse”, with u(r) = log r for all positive real numbers r, can
you determine what value of X will maximize his expected utility?