BE

510 Business Economics 1 - Autumn 2021

Problem Set 1

1. Gamble 𝑔 is characterized by an 80% chance of winning €25 (otherwise €0).

(a) Julie’s utility function is 𝑢! (𝑥) = 𝑥 ".$ . Leonard’s utility function is 𝑢% (𝑥) = 𝑥 & . Determine
the certainty equivalents and the risk premiums of the gamble for Julie and Leonard.
(b) Would a risk-averse individual ever prefer the gamble to receiving €17 for sure? Would
a risk-loving person ever prefer €17 to the lottery? Justify your answers.

2. Kate’s utility for money can be described (at least within a certain range) by the function
𝑢(𝑥) = 0.35+𝑥⁄3 + 400 where 𝑥 represents monetary amounts that she receives or that she
loses. Kate has the opportunity to invest €2,000 in a project that will yield a return of €3,250
if it succeeds and a return of €800 if it fails (in which case 𝑥 = −€1,200). The probability of
success is 0.49.
(a) What is the expected monetary value of the investment?
(b) If she decided to go for the investment, what is Kate’s utility level going to be if the project
succeeds? What if it fails? What is her expected utility if she invests? Will she invest?
(c) Suppose the probability of success is unknown.
(i) Draw a graph that shows Kate’s expected utility from making the investment (on the
vertical axis) for any success probability 𝑝 (on the horizontal axis).
(ii) Construct a second horizontal axis underneath the 𝑝-axis that shows the expected
monetary values of the investment corresponding to the different values of 𝑝.
(iii) Sketch the function that represents the different utility levels Kate would achieve if
she received (in cash and without risk) the monetary amounts shown on your second
horizontal axis. What can we conclude from this?
(d) Determine the range of 𝑝 for which Kate decides to invest. Highlight the point at which
Kate’s preferred option (invest/not invest) changes in your graph.
(e) Assume again that the probability of success is 0.49. Suppose now that if Kate does not
invest, she receives (or must pay) an amount 𝑥. Determine the value of 𝑥 that would make
Kate indifferent between investing and not investing.

 BE 510 Business Economics 1 - Autumn 2021

3. (a) George’s utility function over money is ln (𝑥). How much is he willing to pay for the fol-
lowing gamble? A fair coin is tossed until Tails comes up. If Tails comes up immediately,
the player receives €1; if Heads comes up first and then Tails, the player receives €2; if
Heads comes up twice before Tails, the player receives €4; and so on. That is, the amount
is doubled for every additional Heads in the sequence.
'()
Hint: ∑*
'+) 5 &! 6 = 1

(b) (i) John is given the choice between gamble A, which yields a gain of €160 with probabil-
ity 11⁄36 and a loss of €10 with probability 25⁄36, and gamble B, which yields a gain of
€40 with probability 34⁄36 and a loss of €10 with probability 2⁄36. John decides to play
gamble B. Does his choice reveal information about his risk attitude? If so, what does it
reveal and why? If not, why not?
(ii) John’s certainty equivalent of lottery B is measured to be €35. What does this tell us
about his risk attitude?
(iii) John’s certainty equivalent of lottery A is measured to be €40. Taking the three pieces
of data together (chosen lottery, both certainty equivalents), is John’s behavior consistent
with expected utility theory? If yes, draw a sketch to illustrate a possible utility function
underlying John’s choices. If not, explain why not.

 BE 510 Business Economics 1 - Autumn 2021

Problem Set 1 - Solutions

No guarantees for correctness. If you find errors in the proposed solutions, please let us know.

1. Gamble 𝑔 is characterized by an 80% chance of winning €25 (otherwise €0).

(a) Julie’s utility function is 𝑢! (𝑥) = 𝑥 ".$ . Leonard’s utility function is 𝑢% (𝑥) = 𝑥 & . Determine
the certainty equivalents and the risk premiums of the gamble for Julie and Leonard.
The certainty equivalent asks for the amount of money that makes a person indifferent
between playing out the gamble and receiving a safe amount of money.
Julie’s expected utility from the lottery is
𝑢! (𝑔) = 0.8𝑢(25) + 0.2𝑢(0) = 0.8 ∙ 5 = 4.

An amount 𝑥< for sure gives Julie the same utility level if 𝑢! (𝑥<) = 𝑥< ".$ = 4 = 𝑢! (𝑔). There-
fore, Julie’s certainty equivalent is 𝑥< = €16.
20 is the expected monetary value
of the investment.
𝑢! (𝑥)

5
0.2

3
0.8

0
0 5 10 15 16 20 25 𝑥
0.8 0.2
Leonard’s expected utility from the lottery is
𝑢% (𝑔) = 0.8𝑢(25) + 0.2𝑢(0) = 0.8 ∙ 625 = 500.
An amount 𝑥< for sure gives Leonard the same utility level if 𝑢% (𝑥<) = 𝑥< & = 500 = 𝑢% (𝑔).
Therefore, Leonard’s certainty equivalent is 𝑥< = €22.36.

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Problem Set 1 - Solutions BE 510 Business Economics 1 - Autumn 2021

𝑢" (𝑥)
700
625
600
0.2

500

400

300
0.8

200

100

0
0 5 10 15 20 22.36 25 𝑥
0.8 0.2

The risk premium is the difference between the expected value of a gamble and the cer-
tainty equivalent. The expected value of the gamble here is 0.8 ∙ €25 = €20.
Therefore, the risk premium for Julie is €20 − €16 = €4. The risk premium for Leonard
is €20 − €22.36 = −€2.36. This tells us how much expected value risk-averse Julie is
willing to give up if that removes the risk. Risk-loving Leonard is not willing to pay any
money to remove the risk. Instead, he would demand compensation if the risk was re-
moved.

(b) Would a risk-averse individual ever prefer the gamble to receiving €17 for sure? Would
a risk-loving person ever prefer €17 to the lottery? Justify your answers.
While Julie prefers the €17 to 𝑔 (since her certainty equivalent is €16), somebody else
who is still risk-averse, but not as risk-averse as Julie, might prefer 𝑔 to €17. For example,
that person’s certainty equivalent might be €18, still below 𝑔’s expected value of €20 but
above the €17. A risk-lover, on the other hand, would never prefer the €17 to 𝑔 because
the certainty equivalent for such a person is necessarily above the expected value of €20.

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Problem Set 1 - Solutions BE 510 Business Economics 1 - Autumn 2021

2. Kate’s utility for money can be described (at least within a certain range) by the function
𝑢(𝑥) = 0.35+𝑥⁄3 + 400 where 𝑥 represents monetary amounts that she receives or that she
loses. Kate has the opportunity to invest €2,000 in a project that will yield a return of €3,250
if it succeeds and a return of €800 if it fails (in which case 𝑥 = −€1,200). The probability of
success is 0.49.
(a) What is the expected monetary value of the investment?
It’s 𝐸𝑉 = −2000 + 0.49 ∙ 3250 + 0.51 ∙ 800 = €0.50. Not terribly great and a lot of risk.

(b) If she decided to go for the investment, what is Kate’s utility level going to be if the project
succeeds? What if it fails? What is her expected utility if she invests? Will she invest?
If the project succeeds, Kate’s utility will be

𝑢(−2000 + 3250) = 0.35+1250⁄3 + 400 ≈ 10.

If the project fails, Kate’s utility will be

𝑢(−2000 + 800) = 0.35+−1200⁄3 + 400 = 0.

Her expected utility therefore is 𝑢(Invest) = 0.49 ∙ 10 + 0.51 ∙ 0 = 4.9 utils. She will in-
vest if her expected utility from investing exceeds her expected utility from not investing.
If she does nothing, 𝑥 = 0 (she doesn’t receive or lose anything) and therefore 𝑢(0) =
0.35√400 = 7 utils. Thus, she will not invest.

(c) Suppose the probability of success is unknown.

(i) Draw a graph that shows Kate’s expected utility from making the investment (on the
vertical axis) for any success probability 𝑝 (on the horizontal axis).
Kate’s expected utility from making the investment is 𝑢(Invest) = 10𝑝. This is the red
linear function shown in the graph below.
(ii) Construct a second horizontal axis underneath the 𝑝-axis that shows the expected
monetary values of the investment corresponding to the different values of 𝑝.
The expected monetary value (= −2000 + 3250𝑝 + 800(1 − 𝑝) = −1200 + 2450𝑝)
ranges from –€1,200 (𝑝 = 0, sure failure) to €1,250 (𝑝 = 1, sure success), as shown
below.
(iii) Sketch the function that represents the different utility levels Kate would achieve if
she received (in cash and without risk) the monetary amounts shown on your second
horizontal axis. What can we conclude from this?
Kate’s utility from the expected monetary value is

𝑢(−1200 + 2450𝑝) = 0.35+(−1200 + 2450𝑝)⁄3 + 400 ≈ 10+𝑝.

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Problem Set 1 - Solutions BE 510 Business Economics 1 - Autumn 2021

The relevant graph is shown in blue. Evidently, if we offered Kate an alternative to

making the investment (with its given upside and downside risks) by paying her the
corresponding expected value, she would always—i.e., irrespective of the probability
of success—prefer the corresponding safe alternative (even if that means a sure loss).

(d) Determine the range of 𝑝 for which Kate decides to invest. Highlight the point at which
Kate’s preferred option (invest/not invest) changes in your graph.
Kate will invest if 𝑢(Invest) > 7 (see part (b) for 𝑢(0) = 7). Inserting the result from (c)
we obtain as the condition for investing 10𝑝 > 7 or 𝑝 > 0.7. This is shown below.

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Problem Set 1 - Solutions BE 510 Business Economics 1 - Autumn 2021

At 𝑝 = 0.7 Kate’s expected utility from the investment (represented by the red dashed
line) is 7 and she is indifferent between investing and not investing (point A). For 𝑝 < 0.7
her expected utility is below 7 and she will not invest. For 𝑝 > 0.7 her expected utility is
greater than 7 and she will invest.

Extra question: What is the value of 𝑝 underneath point B in the picture? Answer: It’s the
probability that makes the expected value of the investment equal to zero: −1200 +
2450𝑝 = 0 and hence 𝑝 = 0.4898. What is the role of this point? When Kate does not in-
vest, she effectively receives 0 (no gains or losses), and this corresponds to the expected
value from an investment with success probability 0.4898. Receiving the expected value
0 for sure yields a utility level of 7 for Kate, the same that she gets from the risky invest-
ment with a success probability 0.7. Note: 0.4898 is close to the 0.49 we looked at in parts
(a) and (b). With 𝑝 = 0.49 the expected value is, as seen, +50 cents.

(e) Assume again that the probability of success is 0.49. Suppose now that if Kate does not
invest, she receives (or must pay) an amount 𝑥. Determine the value of 𝑥 that would make
Kate indifferent between investing and not investing.
Kate’s expected utility from investing is, again, 𝑢(Invest) = 0.49 ∙ 10 + 0.51 ∙ 0 =
4.9 utils . Her utility from receiving a safe (positive or negative) amount 𝑥 is 𝑢(𝑥) =
0.35+𝑥⁄3 + 400. These are equal if 0.35+𝑥 ⁄3 + 400 = 4.9 or 𝑥 = −€612. Thus, Kate
would rather pay an amount of up to €612 than invest in this project.

3. (a) George’s utility function over money is ln (𝑥). How much is he willing to pay for the fol-
lowing gamble? A fair coin is tossed until Tails comes up. If Tails comes up immediately,
the player receives €1; if Heads comes up first and then Tails, the player receives €2; if
Heads comes up twice before Tails, the player receives €4; and so on. That is, the amount
is doubled for every additional Heads in the sequence.
'()
Hint: ∑*
'+) 5 &! 6 = 1

Expected utility from the gamble:

1 1 1 1
𝐸𝑈 = 𝑢(1) + 𝑢(2) + 𝑢(4) + 𝑢(8) + ⋯
2 4 8 16
1 1 1 1 1
= ln(1) + ln(2) + ln(4) + ln(8) + ⋯ + ' lnH2'() I + ⋯
2 4 8 16 2
* * *
1 𝑖−1 𝑖−1
= J ' lnH2'() I = J ' ln(2) = ln(2) J ' = ln(2)
2 2 2
'+) '+) '+)

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Problem Set 1 - Solutions BE 510 Business Economics 1 - Autumn 2021

In other words, the expected utility from the gamble is equal to the utility of receiving €2.
Thus, George’s willingness to pay is €2.
(b) (i) John is given the choice between gamble A, which yields a gain of €160 with probabil-
ity 11⁄36 and a loss of €10 with probability 25⁄36, and gamble B, which yields a gain of
€40 with probability 34⁄36 and a loss of €10 with probability 2⁄36. John decides to play
gamble B. Does his choice reveal information about his risk attitude? If so, what does it
reveal and why? If not, why not?
The expected value of Option A is greater than that of Option B:
11 25 34 2
⋅ 160 − ⋅ 10 = 41.94 > 37.22 = ⋅ 40 − ⋅ 10
36 36 36 36
At the same time Option A is clearly riskier than Option B. (Note, by the way: There are
formal measures to quantify the degree of ‘riskiness’ of arbitrary monetary gambles but
we will not deal with them in this module.) We conclude that John must be risk averse.
(ii) John’s certainty equivalent of lottery B is measured to be €35. What does this tell us
about his risk attitude?
This result confirms John’s aversion to risk since his certainty equivalent is lower than
the expected value of the gamble (€35 < €37.22).
(iii) John’s certainty equivalent of lottery A is measured to be €40. Taking the three pieces
of data together (chosen lottery, both certainty equivalents), is John’s behavior consistent
with expected utility theory? If yes, draw a sketch to illustrate a possible utility function
underlying John’s choices. If not, explain why not.
John’s certainty equivalent reveals once again risk aversion, as in (ii). On its own each of
the three pieces of data would be compatible with expected utility theory. However, taken
together the data is not consistent with EUT because when given the choice between A
and B John picks B but when asked to state certainty equivalents he comes up with a
greater monetary amount for A than for B.
This behavioral pattern violates transitivity, a key assumption for the rational choice ap-
proach: From the choice task we know that B is preferred to A, and since John stated that
he is indifferent between playing A and receiving €40, it would follow (via transitivity)
that B is preferred to €40. At the same time John indicated that B is worth €35 to him.
Hence, under transitivity we would obtain that €35 is preferred to €40. Assuming that
more money is preferred to less, there is a contradiction indicating a violation of transi-
tivity.