Final Solutions

Problem 1. (2 points each) Circle T or F. Do NOT give explanations; no partial credit.

(1) FALSE. Someone with CARA utility has constant risk aversion.

(2) FALSE. You will be more likely to buy a winter coat on days that are cold.

(3) FALSE. EDU is time consistent.

(4) TRUE. Yes, —,” violates stationarity.

(5) FALSE. Naive people are indifferent.

(6) TRUE. Yes, you value the future less.

(7) FALSE. It may not be unique as in lecture.

(8) TRUE. This is the definition of risk-loving.

(9) FALSE. Sometimes, the standard model does fine.

(10) TRUE. They have different Arrow-Pratt coefficients.

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Problem 2. If Alice prefers P to Q, it means that

1 –
2 >q
4
2– > 4q

If Ben prefers P to Q, it means that 2— > 4q.

(1) This means that 2– > 4q implies 2— > 4q for all values of q. This is only true if 2— Ø 2–
or — Ø –.

(2) Risk aversion for Ben means — Æ 1. Thus, – Æ 1 so Alice is also risk averse.

(3) We know – Æ 1, but that says nothing about whether — is greater or less than 1. Thus,
we do not know.

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Problem 3. Here are the rewards for Days 1 to 4

1 2 3 4
Day 1 Steve 4 3 2 5
Day 2 Steve 6 2 5
Day 3 Steve 4 5

(1) Day 1 Steve prefers to study on Day 4.

(2) Naive Steve will study on Day 2.

(3) Sophisticated Steve will study on Day 1.

(4) The sophisticated Steve will get drunk and study on Day 4.

(5) The naive will be indifferent between getting drunk or not.

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Problem 4. We solve for the different parts.

(1) Emma’s budget constraint is given by

c2 c3
c1 + + Æ 10
2 4

(2) Setting the constraint to an equality and plugging it back to the Year 1 utility, we get

c2 c3 c2 c3
U (c1 , c2 , c3 ) = 10 ≠ ≠ + +
2 4 3 3
1 1
Since 4
< 3
< 12 , Year 1 Emma will max out c3 and set c1 = 0. This means Year 2
Emma’s budget constraint is
c3
c2 + Æ 20
2
Setting it to an equality and plugging it back to the Year 2 utility, we get

c3 c3
U (c2 , c3 ) = 20 ≠ +
2 3

So Year 2 Emma wants to set c3 = 0 and c2 = 20.

(3) Given that c1 is consumed, the Year 2 budget constraint is

c3
c2 + Æ 2 (10 ≠ c1 )
2

(4) Setting the constraint to an equality and plugging it back to the Year 2 utility, we get

c3 c3
U (c2 , c3 ) = 2 (10 ≠ c1 ) ≠ +
2 3

So Year 2 Emma will set c3 = 0 and c2 = 2 (10 ≠ c1 ). Year 1 Emma now gets

2
U (c1 , c2 , c3 ) = c1 + (10 ≠ c1 )
3

so she sets c1 = 10.

(5) She understands that her Year 2 self will consume everything in Year 2 so she preempts
it by consuming everything in Year 1.

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Problem 5. We solve the two parts:

(1) Let p be Sara’s belief that the drawn ball in Urn 2 is Black. Since she strictly prefers
1
B1 to B2, it means that 2
> p. Since she strictly prefers R1 to R2, it means that
1
2
> 1 ≠ p or p > 12 . This is a contradiction. Sara is ambiguity-averse because she
dislikes betting on unknown probabilities.

(2) Sara will strictly prefer B1 over B2 because

1
◊ 100 > 1min2 p ◊ 100
2 3
ÆpÆ 3
1 1
>
2 3

She will strictly prefer R1 over R2 when

1
◊ 100 > 1min2 (1 ≠ p) ◊ 100
2 3
ÆpÆ 3
1 1
>
2 3