Problem Set #1 Solutions

1)
a) 𝐸𝑉! = 0.5 × 1000 + 0.25 × 600 = 650$
𝐸𝑉" = 0.6 × 1500 − 0.4 × 500 = 700$

b) 𝐸𝑈! = 0.5 × 2 × 6000 + 0.25 × 2 × 5600 + 0.25 × 2 × 5000 = 11300

𝐸𝑈" = 0.6 × 2 × 6500 + 0.4 × 2 × 4500 = 11400

You choose the second

c) 𝐸𝑈! = 0.5 × 6000#.%& + 0.25 × 5600#.%& + 0.25 × 5000#.%& ≈ 1545

𝐸𝑈" = 0.6 × 6500#.%& + 0.4 × 4500#.%& ≈ 1554

You choose the second

d) 𝐸𝑈! = 0.5 × 𝑙𝑛(6000) + 0.25 × 𝑙𝑛(5600) + 0.25 × 𝑙𝑛(5000) ≈ 8.64

𝐸𝑈" = 0.6 × 𝑙𝑛(6500) + 0.4 × 𝑙𝑛(4500) ≈ 8.64

You are (almost) indifferent between the two (if you didn’t use
rounding and you answered one of the two, it’s OK)

2)
a) 𝐸𝑈'()* ,*- = 0.5 × 6050#..# + 0.5 × 4000#..# ≈ 388.04
𝐸𝑈/0- '()* ,*- = 5000#..# ≈ 388.40

The decision maker doesn’t take the bet

(if you used rounding and answered that she’s indifferent between
taking and not taking the bet, it’s OK)

b) 𝐸𝑈'()* ,*- = 0.5 × 51050#..# + 0.5 × 49000#..# ≈ 1947.21

𝐸𝑈/0- '()* ,*- = 50000#..# ≈ 1946.61

The decision maker takes the bet

3)
a) 𝐸𝑈12(3 = 0.5 × 1000 + 0.5 × 2 × (−550) ≈ −50
𝐸𝑈/0- 12(3 ≈ 0

The decision maker doesn’t play

b)
Second Time
First Time Win (𝒑𝟏 = 𝟎. 𝟓) Lose (𝒑𝟏 = 𝟎. 𝟓)
Win (𝒑𝟏 = 𝟎. 𝟓) Probability : 0.5 × 0.5 = 0.25 Probability : 0.5 × 0.5 = 0.25
Outcome : 1000$ + 1000$ = 2000$ Outcome : 1000$ − 550$ = 450$

Lose (𝒑𝟏 = 𝟎. 𝟓) Probability : 0.5 × 0.5 = 0.25 Probability : 0.5 × 0.5 = 0.25
Outcome : −550$ + 1000$ = 450$ Outcome: −550$ − 550$ = −1100$

𝐸𝑈12(3 = 0.5 × 450 + 0.25 × 2 × (−1100) + 0.25 × 2000 ≈ 175

𝐸𝑈/0- 12(3 ≈ 0

The decision maker plays

 c) It is different because of myopic loss aversion (check you
reading material, slide 137). When you myopically evaluate your
stock portfolio at high frequencies, say every day, there will
be many days during which the return on investment in the stocks
will be negative (i.e. you will experience losses). On the other
hand, if you evaluate the performance of the investment in stocks
less frequently, it is more likely that the aggregate return on
the investment is positive. Since losses weigh more heavily than
gains, the frequent comparisons of returns on stocks will lead
to "disappointment" about the performance of your investment in
stocks. When considering performance over longer periods, you
will be happier.

4)
a) 𝐸𝑈4566*7- = (−2) × [−(−1000)]#..& ≈ −355.66

b) 𝐸𝑈80592*:06:/0-;<7= = 0.5 × (−2)(2000)#..& + 0.5 × 0 ≈ −299.07

Ben should take the gamble because −299,07 > −355.66

c) If he has been winning, the “Double-or-Nothing” stakes would be

all in the domain of gains. As a result, he would act an Expected
Utility maximiser and because he is risk averse, he would not
take the bet. Check slide 65 in your reading material, where 10$
is the double of 5$ and the 50-50 “Double-or-Nothing” bet would
be in the middle of the line connecting 𝑈(0) with 𝑈(10), so lower
than 𝑈(5).

5)
!.#!.#!
a) 𝜋(0.8) = (!.#!.#!%(&'!.#)!.#!)$/!.#! ≈ 0.599 ; 𝜋(1) = 1

𝐸𝑈>?@ABC ! = 0.599 × 4000 = 2396

𝐸𝑈>?@ABC " = 3000

He chooses the second gamble

!.!) !.#! !.!*!.#!

b) 𝜋(0.04) = (!.!)!.#!%(&'!.!))!.#! )$/!.#! ≈ 0.12 ; 𝜋(0.05) = (!.!*!.#!%(&'!.!*)!.#! )$/!.#! ≈ 0.13

𝐸𝑈>?@ABC ! = 0.12 × 4000 = 480

𝐸𝑈>?@ABC " = 0.13 × 3000 = 390

He chooses the first gamble

6) The trick here was to understand that the utility function is:
(𝑐 CDC
𝑢(𝑐, 𝑚) =  3 × BC − 𝑟
CE𝑐) + BC
(𝑚 CDC
− 𝑟CE
𝑚)
𝑢(𝑐) 𝑢(𝑚)

a) (rc = 0; rm = 0):

If he buys the car, he gets c=1 and m=-2, so:

𝑈HIJ = 3 × (1 − 0) + 2 × (−2 − 0) = −1
 If he doesn’t buy the car, he gets c=0 and m=0, so:
𝑈KLM:HIJ = 3 × (0 − 0) + (0 − 0) = 0

So, he would not buy the car

b) (rc = 1; rm = −2):

If he buys the car, he gets c=1 and m=-2, so:

𝑈HIJ = 3 × (1 − 1) + [−2 − (−2)] = 0

If he doesn’t buy the car, he gets c=0 and m=0, so:

𝑈KLM:HIJ = 3 × 2 × (0 − 1) + [0 − (−2)] = −4

So, he would buy the car

c) The endowment effect is the phenomenon where people put a higher

value in a good or service once they actually possess it or the
property right to it.

From the answer in a, we can infer that the value Batman places
on the car (when he doesn’t expect to buy it) is lower than 2$,
because he is not willing to sacrifice 2$ to get it.

From the answer in b, we can infer that the value Batman places
on the car (when he expects to buy it) is higher than 2$, because
now he is willing to sacrifice 2$ to get it.

That means that we have an endowment effect (value in b > value

in a) but this time not caused by the actual possession of the
good (as in the typical endowment effect) but by expectations