Supplementary Answers for Problem Set 1

Exercise 1 Argue that if relation satises independence. has an expected-utility (EU) representation then it

Answer: If the preference ordering has an EU representation then p p Ep [u (x)] Ep [u (x)]. So if p p then also Ep [u (x)] Ep [u (x)] for any 0 1. Now take any lottery p and add (1 ) Ep [u (x)] to both sides of our inequality. This gives Ep [u (x)] + (1 ) Ep [u (x)] Ep [u (x)]+(1 ) Ep [u (x)], and using the linearity of expectations we know this is equivalent to Ep+(1)p [u (x)] Ep +(1)p [u (x)].1 Since we have an EU representation it follows that p + (1 ) p p + (1 ) p (remember, p + (1 ) p is just another lottery, we could call it p if we wanted and apply the EU representation denition) Exercise 2 Argue the following: If U is an expected-utility representation of , then it satises the following linearity property: for any pair of lotteries p and p and any number 0 1, U (p + (1 ) p ) = U (p) + (1 ) U (p ). Answer: The argument is more or less the same as Exercise 1 but in reverse. When we notice that we can dene U (p) = Ep [u (x)] we see that U (p + (1 ) p ) = Ep+(1)p [u (x)]. Using the previous approach we get Ep+(1)p [u (x)] = Ep [u (x)] + (1 ) Ep [u (x)] = U (p) + (1 ) U (p ). Exercise 3 Consider a consumer with expected-utility preferences and cardinal utility index u(x) = x over non-negative wealth levels. Suppose that she faces uncertain wealth, distributed uniformly over the interval (0; 1). How much would she be willing to pay to insure against this wealth uncertainty? How does your answer change if u(x) = x? What if u(x) = x2 ? Answer: This question is essentially asking what the certainty equivalent wealth of our hypothetical decision maker is. That is to say, what is the minimum level of certain wealth they would accept in order not to face uncertainty over x?. Another way to phrase this would be to ask how much less than the expectation would they accept in order to remove the risk?.
see this just write the the left hand side of this inequality as integrals: Ep [u (x)] + (1 )Ep [u (x)] = X u (x) p (x) dx + (1 ) X u (x) p (x) dx = X u (x) p (x) dx + X u (x) (1 ) p (x) dx = X u (x) p (x) + (1 ) p (x) dx, where p (x) is the density function induced by lottery p.
1 To

 So, if u(x) = x and x U (0, 1) and we need to nd the that satises u(E [x] ) = E [u(x)]: E [x] =
0 1

u(x)f (x)dx
1 0

1 2 3 = x2 2 3
1 18 4 9

which gives = in this case, meaning our certainty equivalent wealth is if u(x) = x. If u(x) = x then = 0 and if u(x) = x2 then = 232 < 0, 3 which would imply this person has to be paid not to gamble. Exercise 4 Suppose that u (x) = exp (x). What is the individuals coecient of absolute risk aversion? How does it depend on x? What u(x) = x1 / (1 ) if when = 1 ? What if u (x) = ln (x) ? What if u (x) = x ? What if u (x) = x ? What if u (x) = x2 ? Answer: The coecient of absolute risk aversion is A (x) = u (x) /u (x). For u (x) = exp (x) we get that u (x) = exp (x) and u (x) = 2 exp (x). This means that A (x) = , a constant which does not depend on x. If you carry out the same derivation for the other utility functions you will see that in general A (x) does depend on x, but for u (x) = exp (x), it does not (this is called a Constant Absolute Risk Aversion (CARA) utility function). Exercise 5 For the cardinal utility indicies dened in Exercise 4. What is the individuals coecient of relative risk aversion? How does it depend on x? Answer: The coecient of relative risk aversion is R (x) = xu (x) /u (x). For u(x) = x1 / (1 ) we get that u (x) = x and u (x) = x1 . This means that R (x) = , a constant which does not depend on x. Again, if you carry out the same derivation for the other utility functions you will see that in general R (x) does depend on x, but for u(x) = x1 / (1 ), it does not (this is called a Constant Relative Risk Aversion (CRRA) utility function). Exercise 3 (from the lecture notes) Argue that independence of implies the following for any p and p : we have that

1. If p p then for any 0 1 and any lottery p p + (1 ) p p + (1 ) p .

Answer: p p p p and p p. Combining this with the independence of gives us that p + (1 ) p p + (1 ) p and p + (1 ) p p + (1 ) p . Both are weakly preferred to each other and therefore we are indierent. 2. If for some 0 1 and some p we have that if p + (1 ) p p + (1 ) p then p p . Answer: This is essentially the reverse of the argument given above. 3. If p p then for any 0 < < 1 and any lottery p , p + (1 ) p p + (1 ) p . Answer: p p p p and p p, (where p p means p p is not true). Again combining this with the independence of gives us that p + (1 ) p p + (1 ) p and p + (1 ) p p + (1 ) p . Using the denition of we get p + (1 ) p p + (1 ) p . 4. If for some 0 < < 1 and some p we have that if p + (1 ) p p + (1 ) p then p p . Answer: This is again the reverse of the argument given above. 5. If p p and 0 < < 1, then p p + (1 )p and p + (1 )p p.

Answer: If we take p as our lottery p and then some 0 < < 1 then independence gives p + (1 )p p + (1 )p (due to the answer in part 3). Now if we dene = (1 ) we will get p + (1 )p p + (1 )p , which gives the result we need. For the second part just use p as p and repeat the same argument.