Microeconomics Patrice De Micco

Choices under uncertainty

Exercises
1) There is a 45% chance that Real Madrid will win over Barcelona in their next match. Julio, who initially
owns 100 euros, can buy for 36 euros a small laboratory where he could produce 80 Real Madrid T-shirts. If
Real Madrid wins, all shirts will be sold (for 1 euro each) and hence Julio’s payoff would be 100 − 36 + 80 =
144 euros. If Real Madrid loses, no shirt will be sold, so Julio’s payoff would be 100 − 36 = 64 euros. Julio’s
utility function of money is 𝑈(𝑥) = √𝑥.

a) What is Julio’s expected payoff if he chooses to make the investment? Will Julio choose to make the
investment?
b) Claudio, a friend of Julio’s, suggests an alternative: buy the firm to make Barcelona T-shirts instead of Real
Madrid T-shirts. This way, Julio’s payoff would be 144 euros if Real Madrid loses and 64 euros if Real Madrid
wins. Should Julio follow Claudio’s advice?
c) Manuel, another friend of Julio’s, suggests a third alternative: buy the firm and make 40 Real Madrid T-
shirts and 40 Barcelona T-shirts. This way, whatever the result of the match, Julio would sell exactly 40 of the
80 T-shirts produced, getting payoff 100 − 36 + 40 = 104 with certainty. Should Julio follow Manuel’s
advice or choose the best alternative computed in point b) above?

2) Mark’s wealth is 𝑉 = 14400. Part of this wealth, 𝐷 = 4400, can be lost in a theft. The probability of theft
is 20%. Mark’s utility function for money is 𝑈(𝑥) = √𝑥.

a) Compute expected value, expected utility, certainty equivalent and risk premium
b) Compute the largest premium Mark is willing to pay for full insurance.
c) Assume now that Mark can buy for 850 an anti-theft system that would reduce the probability of theft to
zero. Explain why no insurance company would be willing to offer Mark a full-insurance policy that Mark
would prefer to the anti-theft system.

3) John owns a car worth 10000 euros. There is a 10% chance that the car will be stolen. John’s utility function
is 𝑈(𝑥) = √𝑥, where x denotes John’s wealth.

a) Compute expected payoff, expected utility, certainty equivalent and risk premium.
b) An insurance company, Premium, offers John a full insurance contract for a price of 1800 euros. Will John
accept?
c) Another insurance company, the low-cost company Asso, offers John a cheaper, partial insurance contract:
for a price of 1550 euros, Asso will reimburse John 7000 euros in the event that the car gets stolen. What is
the expected value of John’s wealth, should he accept Asso’s offer? Does John prefer Asso’s offer to his best
option in point b) above?

4) John owns a car worth 10000 euros. There is a 20% chance that the car will be stolen. John’s utility function
is 𝑈(𝑥) = √𝑥, where x denotes John’s wealth.

a) Compute expected value, expected utility, certainty equivalent and risk premium.
b) An insurance company, Premium, offers John a full insurance contract for a price of 3000 euros. Will John
accept?
c) Another insurance company, the low-cost company Asso, offers John a cheaper, partial insurance contract:
for a price of 2400 euros, Asso will reimburse John 7000 euros in the event that the car gets stolen. What is
Microeconomics Patrice De Micco

the expected value of John’s wealth, should he accept Asso’s offer? Does John prefer Asso’s offer to his best
option in point b) above?

5) Armando’s wealth is constituted by 10000 euros deposited in a bank and by a scooter that is worth 2100
euros. The money deposited in the bank is riskless, but there is a 20% chance that the scooter will be stolen.
Armando’s utility function is 𝑈(𝑥) = √𝑥, where 𝑥 denotes Armando’s wealth.

a) Compute expected value, expected utility and certainty equivalent of Armando’s wealth.
b) Armando could buy full insurance for his scooter at a price of 300 euros. Will Armando buy the insurance?
c) Alternatively, Armando could rent a garage where to keep his scooter. This would reduce the probability
of theft to 10%. Assuming that renting a garage costs 90 euros, what is the expected value of Armando’s
wealth, should he decide to rent the garage? Does Armando prefer renting a garage or his best option in
point b) above?

6) John owns a car worth 10000 euros. There is a 10% chance that the car will be stolen. John’s utility function
is 𝑈(𝑥) = √𝑥, where x denotes John’s wealth.

a) Compute expected value, expected utility, certainty equivalent and risk premium.
b) An insurance company, Premium, offers John a full insurance contract for a price of 1800 euros. Will John
accept?
c) Another insurance company, the low-cost company Asso, offers John a cheaper, partial insurance contract:
for a price of 1550 euros, Asso will reimburse John 7000 euros in the event that the car gets stolen. What is
the expected value of John’s wealth, should he accept Asso’s offer? Does John prefer Asso’s offer to his best
option in point b) above?
Microeconomics Patrice De Micco

Choices under uncertainty

Exercises

1) There is a 45% chance that Real Madrid will win over Barcelona in their next match. Julio, who initially
owns 100 euros, can buy for 36 euros a small laboratory where he could produce 80 Real Madrid T-shirts. If
Real Madrid wins, all shirts will be sold (for 1 euro each) and hence Julio’s payoff would be 100 − 36 + 80 =
144 euros. If Real Madrid loses, no shirt will be sold, so Julio’s payoff would be 100 − 36 = 64 euros. Julio’s
utility function of money is 𝑈(𝑥) = √𝑥.

a) What is Julio’s expected payoff if he chooses to make the investment? Will Julio choose to make the
investment?
The expected payoff is 0,45 ∗ 144 + 0,55 ∗ 64 = 100. Since the investment involves risk, Julio prefers his
initial, riskless wealth of 100 euros and hence will not make the investment. Indeed, in expected utility terms,
0,45 ∗ √144 + 0,55 ∗ √64 = 9,8 < √100 = 10.

b) Claudio, a friend of Julio’s, suggests an alternative: buy the firm to make Barcelona T-shirts instead of Real
Madrid T-shirts. This way, Julio’s payoff would be 144 euros if Real Madrid loses and 64 euros if Real Madrid
wins. Should Julio follow Claudio’s advice?
Julio should follow the advice, because 0,55 ∗ √144 + 0,45 ∗ √64 = 10,2 > √100 = 10.

c) Manuel, another friend of Julio’s, suggests a third alternative: buy the firm and make 40 Real Madrid T-
shirts and 40 Barcelona T-shirts. This way, whatever the result of the match, Julio would sell exactly 40 of the
80 T-shirts produced, getting payoff 100 − 36 + 40 = 104 with certainty. Should Julio follow Manuel’s
advice or choose the best alternative computed in point b) above?
Julio should not follow Manuel’s advice, because the certainty equivalent corresponding to Claudio’s
suggested alternative is higher: (10,2)2 = 104,04 > 104.

2) Mark’s wealth is 𝑉 = 14400. Part of this wealth, 𝐷 = 4400, can be lost in a theft. The probability of theft
is 20%. Mark’s utility function for money is 𝑈(𝑥) = √𝑥.

a) Compute expected value, expected utility, certainty equivalent and risk premium
EV = 0.8*14400+0.2*10000 = 13520
EU = 0.8*√14400 + 0.2*√10000 = 116
CE = 13456
RP = EP – CE = 64

b) Compute the largest premium Mark is willing to pay for full insurance.
The largest premium is defined by the equality 14400 − 𝑃 = 13456, or equivalently √14400 − 𝑃 = 116,
that is, 𝑃 = 944. Alternatively, the largest premium can be computed as the sum of expected loss and risk
premium: 0.2 ∗ 4400 + 64 = 944.

c) Assume now that Mark can buy for 850 an anti-theft system that would reduce the probability of theft to
zero. Explain why no insurance company would be willing to offer Mark a full-insurance policy that Mark
would prefer to the anti-theft system.
Since the anti-theft system is equivalent to a full insurance, Mark would prefer an insurance policy with
premium P only if P < 850. But by offering such a premium the insurance company would make negative
profits, because the expected loss is 0,2*4400=880>850.
Microeconomics Patrice De Micco

3) John owns a car worth 10000 euros. There is a 10% chance that the car will be stolen. John’s utility function
is 𝑈(𝑥) = √𝑥, where x denotes John’s wealth.

a) Compute expected payoff, expected utility, certainty equivalent and risk premium.
EV = 0.9*10000+0.1*0 = 9000
EU = 0.9*√10000 + 0.1*√0 = 90
CE = 8100
RP = EV – CE = 900

b) An insurance company, Premium, offers John a full insurance contract for a price of 1800 euros. Will John
accept?
Yes, because John would end up with a sure wealth of 10000-1800=8200 and this is greater than 8100, the
certainty equivalent of the initial uncertain situation.

c) Another insurance company, the low-cost company Asso, offers John a cheaper, partial insurance contract:
for a price of 1550 euros, Asso will reimburse John 7000 euros in the event that the car gets stolen. What is
the expected value of John’s wealth, should he accept Asso’s offer? Does John prefer Asso’s offer to his best
option in point b) above?
The expected value of John’s wealth would be 0.9*(10000-1550)+0.1*(7000-1550)=8150, less than when John
takes Premium’s offer. Moreover, unlike in that case, he would be facing uncertainty. Thus, being risk averse,
John will prefer Premium to Asso.

4) John owns a car worth 10000 euros. There is a 20% chance that the car will be stolen. John’s utility function
is 𝑈(𝑥) = √𝑥, where x denotes John’s wealth.

a) Compute expected value, expected utility, certainty equivalent and risk premium.
EV = 0.8*10000+0.2*0 = 8000
EU = 0.8*√10000 + 0.2*√0 = 80
CE = 6400
RP = EV – CE = 1600

b) An insurance company, Premium, offers John a full insurance contract for a price of 3000 euros. Will John
accept?
Yes, because John would end up with a sure wealth of 10000-3000=7000 and this is greater than 6400, the
certainty equivalent of the initial uncertain situation.

c) Another insurance company, the low-cost company Asso, offers John a cheaper, partial insurance contract:
for a price of 2400 euros, Asso will reimburse John 7000 euros in the event that the car gets stolen. What is
the expected value of John’s wealth, should he accept Asso’s offer? Does John prefer Asso’s offer to his best
option in point b) above?
The expected value of John’s wealth would be 0.8*(10000-2400)+0.2*(7000-2400)=7000, exactly the same as
when John takes Premium’s offer. However, unlike in that case, he would be facing uncertainty. Thus, being
risk averse, John will prefer Premium to Asso.
Alternatively: choosing Premium gives expected utility 1 ∗ √7000 ≈ 83.66 while choosing Asso gives
expected utility 0.8 ∗ √10000 − 2400 + 0.2 ∗ √7000 − 2400 ≈ 83.31, thus John will prefer Premium to
Asso.
Microeconomics Patrice De Micco

5) Armando’s wealth is constituted by 10000 euros deposited in a bank and by a scooter that is worth 2100
euros. The money deposited in the bank is riskless, but there is a 20% chance that the scooter will be stolen.
Armando’s utility function is 𝑈(𝑥) = √𝑥 , where 𝑥 denotes Armando’s wealth.

a) Compute expected value, expected utility and certainty equivalent of Armando’s wealth.
EV = 0.8*12100+0.2*10000 = 11680
EU = 0.8*√12100 + 0.2*√10000 = 108
√𝐶𝐸= EU
√𝐶𝐸= 108
CE=11664

b) Armando could buy full insurance for his scooter at a price of 300 euros. Will Armando buy the insurance?
Yes, because this way he would have a sure wealth of 10000-300+2100=11800, and this is higher than 11664,
the certainty equivalent of the initial risky situation.

c) Alternatively, Armando could rent a garage where to keep his scooter. This would reduce the probability
of theft to 10%. Assuming that renting a garage costs 90 euros, what is the expected value of Armando’s
wealth, should he decide to rent the garage? Does Armando prefer renting a garage or his best option in
point b) above?
Armando will prefer the insurance, because the expected value of his wealth would be the same, 0.9*(12100-
90)+0.1*(10000-90)=11800, but his wealth would not be riskless.
Alternative answer: choosing the insurance gives expected utility 1∗√11800≈108.62 while renting the garage
gives expected utility 0.9∗√12100−90+0.1∗√10000−90≈108.58, thus Armando prefers the insurance.

6) John owns a car worth 10000 euros. There is a 10% chance that the car will be stolen. John’s utility function
is 𝑈(𝑥) = √𝑥, where x denotes John’s wealth.

a) Compute expected value, expected utility, certainty equivalent and risk premium.
EV = 0.9*10000+0.1*0 = 9000
EU = 0.9*√10000 + 0.1*√0 = 90
CE = 8100
RP = EV – CE = 900

b) An insurance company, Premium, offers John a full insurance contract for a price of 1800 euros. Will John
accept?
Yes, because John would end up with a sure wealth of 10000-1800=8200 and this is greater than 8100, the
certainty equivalent of the initial uncertain situation.

c) Another insurance company, the low-cost company Asso, offers John a cheaper, partial insurance contract:
for a price of 1550 euros, Asso will reimburse John 7000 euros in the event that the car gets stolen. What is
the expected value of John’s wealth, should he accept Asso’s offer? Does John prefer Asso’s offer to his best
option in point b) above?
The expected value of John’s wealth would be 0.9*(10000-1550)+0.1*(7000-1550)=8150, less than when John
takes Premium’s offer. Moreover, unlike in that case, he would be facing uncertainty. Thus, being risk averse,
John will prefer Premium to Asso.