Problem set 8

1. Consider St. Petersburg paradox discussed in the lecture. We have shown that the expected value
is given by:
𝐸𝑉 = (1/2)2 + (1/2)222 + (1/2)323 + ⋯
Show that probabilities of this gamble add up to 1.
Solution:
We have to show that (1/2) + (1/2)2 + (1/2)3 + ⋯ = 1
The left-hand side is a geometric series with the first term equal to ½ and the quotient equal to ½.
Therefore, the sum of this series is
1/2
=1
1 − 1/2

2. Consider the two following two lotteries discussed in the lecture.

Internet company Public utility company

Price Probability Price Probability
120 0.3 120 0.1
100 0.4 100 0.8
80 0.3 80 0.1

Suppose that a decision maker has the utility function 𝑈 = √100𝐼 where I denotes the payoff of the
lottery.

a) Is the decision maker risk-neutral, risk-averse, or risk-seeking? Explain.

Solution:
The decision maker is risk-averse, because his utility function is characterized by diminishing marginal
utility:
𝑑𝑈 5 𝑑𝑀𝑈 𝑑𝑀𝑈 5
𝑀𝑈 = 𝑑𝐼 = 𝐼 and 𝑑𝐼 = 𝑑𝐼 = − 3 < 0
√ 2√𝐼

b) What is the expected utility from investing in Internet stock?

Solution:
Expected utility of investing in Internet stock:
𝐸𝑈=0.3√8,000+0.4√10,000+0.3√12,000=99.7

c) What is the expected utility of investing in public utility stock?

Solution:
Expected utility of investing in public utility stock:
𝐸𝑈=0.1√8,000+0.8√10,000+0.1√12,000=99.9

d) Which lottery does the decision maker prefer?

Solution:
Since investing in the public utility company’s stock has the higher expected utility, a risk-averse
decision maker prefers it to the Internet company’s stock.

3. Consider the following decision discussed in the lecture. Your salary at the established company is
a sure thing—that is, the probability of receiving $54,000 is 1 (no other outcome is possible). Your
salary at the start-up company is a lottery—a 0.5 chance of receiving $4,000 and a 0.5 chance of
receiving $104,000. Suppose that your utility function is given by 𝑈 = √𝐼
a) Find the risk premium associated with the start-up company’s salary offer.
Solution:
0.5√104,000+0.5√4,000=√54,000−𝑅𝑃
and therefore RP = 16,801.

b) Suppose that the start-up company offered you a zero salary but a bonus of $108,000 if the
company meets its growth targets. (This has the same expected value but a higher variance than the
initial offer, as you can easily verify.) What is the risk premium associated with this offer?
Solution:
0.5√108,000+0.5√0=√54,000−𝑅𝑃
and therefore RP = 27,000.
This confirms that as the variance of a lottery increases, holding the expected value fixed, so does the
risk premium.

4. Economic laws also hold in fairy tales. Consider a princess who decides to marry a man who will kill
a dangerous dragon. Three princes consider marrying her.
a) Assume that for each prince, the utility of the marriage with the princess is 1. Each of them kills
the dragon with the probability 0.3. If he is killed, he receives 0. Assume that all the three princes are
identical, except one of them has negative unobservable characteristics (he is e.g., a weirdo, mass
murderer, economist, etc.). This means that if he does not marry this princess, he will remain single
forever, which will him the utility of 0.1. The other two princes are fine and they can find someone
else, which will give them utility equal to 0.5. Who will attempt to kill the dragon?
Solution:
The princes decide between trying to kill the dragon and finding someone else:
For the weird prince: (0.3)1 + (2/3)0 > 0.1
For the other two princes: (0.3)1 + (2/3)0 < 0.5
Only the weird prince will try to kill the dragon.

b) Assume now that for each prince, the utility of the marriage with the princes is 1, except for one
who values the marriage higher (e.g., because he actually loves her). His utility from this marriage is
equal to 2. Otherwise, they are identical: if they are killed, they receive 0 and they get killed with the
probability 0.3. If they do not marry the princess, they each of them can find someone else and the
value of this alternative marriage is 0.5 for reach of them. Who will attempt to kill the dragon now?
Solution:
The princes decide between trying to kill the dragon or finding someone else:
For Mr. Right: (0.3)2 + (2/3)0 > 0.5
For the other two princes: (0.3)1 + (2/3)0 < 0.5
Only Mr. Right will try to kill the dragon.

c) Finally, assume that one of the princess is a good fighter and will kill the dragon with probability
0.9, whereas the other two will kill the dragon with the probability 0.3. Otherwise the princes are
identical. The utility of marriage with the princess is 1, the utility of marriage with someone else is
0.5. Who will attempt to kill the dragon now?
Solution:
The princes decide between trying to kill the dragon or finding someone else:
For the fighter: (0.9)1 + (2/3)0 > 0.5
For the other two princes: (0.3)1 + (2/3)0 < 0.5
Only the fighter will try kill the dragon.

d) In fairy tales (as well as in reality), princesses often require some sacrifices from their suitors
before they decide to marry them (they have to e.g., kill a dragon, bring presents, etc.) Is it a good
way to select a partner? Why or why not?
Solution:
Requiring a sacrifice is a screening device which should help to identify hidden characteristics of the
suitors. However, this screening device has to be carefully chosen because it can lead to an adverse
selection, as in question a), or it can possibly reveal other characteristics (such as fighting skills in b))
that are not necessarily important in marriage.