Problem Set 1

Due date: April 26 (Wed) Midnight. 70 points total.

Problem 1. True for False (3 points each).

(1) Expected utility cannot account for a person choosing lotteries according to expected
value. (T / F)

(2) It’s possible to tell whether a person has utility u1 (x) = log x or u2 (x) = log (4x) from
their choices. (T / F)

(3) Suppose you choose a stock if and only if all your friends also choose that stock. Your
choices could be incomplete. (T / F)

(4) The reflection and isolation effects can appear in the same problem. (T / F)

(5) Standard (i.e. non-behavioral) economics can explain why some people gamble. (T /
F)

1
Problem 2. This problem takes you through the formal definition of risk aversion / risk
loving. Given a lottery P , let E (P ) be the expected value of the lottery P . For example, if
P = ($10, 0.5; $0, 0.5), then

E (P ) = 0.5 ◊ 10 + 0.5 ◊ 0 = 5

We say a person is

• Risk averse if he chooses E (P ) dollars for sure over the lottery P

• Risk neutral if he is indifferent between E (P ) dollars and the lottery P

• Risk loving if he chooses the lottery P over E (P ) dollars for sure.

One way to measure “how” risk averse someone is is to use something called the Arrow-
Pratt coefficient of risk aversion. Given a vNM utility u, the Arrow-Pratt coefficient is

≠uÕÕ (x)
r (x) =
uÕ (x)

(1) Ann has vNM utility u1 (x) = x, Bob has utility u2 (x) = log (2x + 1) and Carl has
utility u3 (x) = x3 . Who is risk neutral, risk averse and risk loving? (5 points)

(2) Consider the lottery P again. Find the dollar amount x such that each person is
indifferent between the lottery P and $x (x is the certainty equivalent of P ) (10
points)

(3) Calculate the Arrow-Pratt coefficients for everyone. How do they compare? Does this
agree with your answers before? (10 points)

(4) Calculate the Arrow-Pratt coefficient for utility u (x) = ≠e≠flx where fl > 0. This type
of utility is called Constant Absolute Risk Aversion (CARA). Why do you think
it’s called CARA? (5 points)

x1≠fl
(5) Calculate the Arrow-Pratt coefficient for utility u (x) = 1≠fl
where fl > 0. This type
of utility is called Constant Relative Risk Aversion (CRRA). Why do you think
it’s called CRRA? (5 points)