Microeconomics: Theory and Applications with Calculus, 4e, Global Edition (Perloff)

Chapter 16 Uncertainty

16.1 Assessing Risk

1) Although he is very poor, Al plays the million-dollar lottery every day because he is certain
that one day he will win. Al makes this calculation based upon
A) the frequency of past outcomes.
B) subjective probability.
C) knowledge of all possible outcomes.
D) tossing a coin.
Answer: B

2) Your friend Dimitre tells you that he thinks that his favorite basketball team has a 70% chance
of winning the next game. This is an example of
A) an objective probability.
B) a subjective probability.
C) a risk-averse statement.
D) Friedman-Savage preferences.
Answer: B

3) You draw colored balls out of a bag. You draw a red ball 30% of the time and a blue ball 70%
of the time. For each draw, the blue outcome and the red outcome are
A) mutually exclusive.
B) exhaustive.
C) Both A and B.
D) None of the above.
Answer: C

4) If there are 10,000 people in your age bracket, and 10 of them died last year, an insurance
company believes that the probability of someone in that age bracket dying this year would be
A) 0.
B) .001.
C) .0001.
D) 1,000.
Answer: B

5) People in a certain group have a 0.3% chance of dying this year. If a person in this group buys
a life insurance policy for $3,300 that pays $1,000,000 to her family if she dies this year and $0
otherwise, what is the expected value of a policy to the insurance company?
A) $0
B) $300
C) $3,000
D) $3,300
Answer: B

6) In a small town, it snowed 10 times on Christmas Eve during 25 years. What is the frequency
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of snowing on Christmas Eve in that small town?
A) 10
B) 25
C) 2.5
D) 0.4
Answer: D

7) Expected value represents

A) the actual payment one expects to receive.
B) the average of all payments one would receive if one undertook the risky event many times.
C) the payment one receives if he or she makes the correct decision.
D) the payment that is most likely to occur.
Answer: B

8) On any given day, a salesman can earn $0 with a 40% probability, $100 with a 40%
probability, or $300 with a 20% probability. His expected earnings equal
A) $0.
B) $100 because that is the most likely outcome.
C) $100 because that is what he will earn on average.
D) $200 because that is what he will earn on average.
Answer: C

9) On any given day, a salesman can earn $0 with a 30% probability, $100 with a 20%
probability, or $300 with a 50% probability. His expected earnings equal
A) $0.
B) $100.
C) $150.
D) $170.
Answer: D

10) On any given day we know a salesman can earn $0 with a 40% probability, $100 with a 20%
probability or $300 with 40% probability. His expected earnings equal
A) $0.
B) $140.
C) $300.
D) It cannot be determined from the available information.
Answer: B

11) Assume the following. In location A yearly temperatures range from -30°F to 100°F and in
location B yearly temperatures range from 55°F to 75°F. In both locations the average yearly
temperature equals 65°F. We can conclude that
A) temperature in location A has a higher variance.
B) temperature in location B has a higher standard deviation.
C) temperature in location A has a lower standard deviation.
D) temperatures in both locations have the same standard deviation but different variances.
Answer: A

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12) Sarah buys little stuffed animals for $5 each. They come in different varieties. If the producer
stops making (retires) a certain variety, a stuffed animal of that variety will be worth $100;
otherwise it is worth $0. There is 50% chance that any variety will be retired. When Sarah buys
her next stuffed animal, the expected profit is
A) $50.
B) $47.50.
C) $45.
D) $0.
Answer: C

13) Sarah buys little stuffed animals for $5 each. They come in different varieties. If the producer
stops making (retires) a certain variety, a stuffed animal of that variety will be worth $100;
otherwise it is worth $0. There is 50% chance that any variety will be retired. What is the value
to Sarah of knowing ahead of time whether a variety will be retired?
A) $50
B) $5
C) $2.50
D) $0
Answer: C

14) Lisa runs a local flower shop. If it rains on Valentine's Day and she opens the shop, she will
lose $200. If it does not rain on Valentine's Day, she will earn $500 dollars as profits. What is
Lisa's expected profit on Valentine's Day if she only knows that there is a 30% chance of rain that
day?
A) $350
B) $290
C) $200
D) $150
Answer: B

15) Lisa runs a local flower shop, if it rains on Valentine's Day and she opens the shop, she will
lose $200. If it does not rain on Valentine's Day, she will earn $500 dollars as profits. The chance
of rain is 30%, what is Lisa's gain from perfect information about weather conditions on the
forthcoming Valentine's Day?
A) 50
B) 60
C) 90
D) 150
Answer: B

16) Lisa runs a local flower shop, if it rains on Valentine's Day and she opens the shop, she will
lose $200. If it does not rain on Valentine's Day, she will earn $500 dollars as profits. The chance
of rain is 30%, the standard deviation of the profits Lisa could earn on Valentine's Day is
A) 198.17.
B) 135.61.
C) 432.43.
D) 290.
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Answer: A

17) If a payout is certain to occur, then the variance of that payout equals
A) zero.
B) one.
C) the expected value.
D) the expected value squared.
Answer: A

18) A lottery game pays $500 with .001 probability and $0 otherwise. The variance of the payout
is
A) 15.8.
B) 249.50.
C) 249.75.
D) 499.
Answer: C

19) All else held constant, as the variance of a payoff increases, the
A) expected value of the payoff increases.
B) risk of the payoff increases.
C) expected value of the payoff decreases.
D) risk of the payoff decreases.
Answer: B

22) On any given day, a salesman can earn $0 with a 20% probability, $100 with a 40%
probability, or $300 with a 20% probability. Calculate the expected value and variance of his
earnings, and interpret.
Answer: E(X) = (0 ∗ .2) + (100 ∗ .4) + (300 ∗ .2) = $100
Variance(X) = .2(0 - 100)2 + .4(100 - 100)2 + .2(300 - 100)2 = 2000 + 0 + 8000 = 10,000.

E(X) tells us that her earnings will average $100 per day if she stays at this job over a long time
period. The variance is a measure of how risky her income is.

24) Sarah buys little stuffed animals for $5 each. They come in different varieties. If the producer
stops making (retires) a certain variety, a stuffed animal of that variety will be worth $100;
otherwise it is worth $0. There is 25% chance that any variety will be retired. For the purchase of
an individual animal, what is the value to Sarah of knowing ahead of time whether or not that
variety will be retired?
Answer: If Sarah did not know whether a variety is to be retired, her expected value of a
purchase is (.75 ∗ -5) + (.25 ∗ 95) = -3.75 + 23.75 = $20.
If she knows ahead of time that a variety won't be retired, she won't buy one. So her expected
value becomes (.75 ∗ 0) + (.25 ∗ 95) = $23.75.
The information that a variety will or will not be retired is worth $3.75 to her.

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16.2 Attitudes Toward Risk

1) The above figure shows Bob's utility function. He currently has $100 of wealth, but there is a
50% chance that it could all be stolen. The midpoint of the chord that runs from zero and
intersects the utility function where wealth is 100, represents Bob's
A) risk premium.
B) expected utility of receiving $50 with certainty.
C) expected utility of receiving $0 50% of the time and $100 50% of the time.
D) risk neutrality.
Answer: C

2) The above figure shows Bob's utility function. He currently has $100 of wealth, but there is a
50% chance that it could all be stolen. Bob's expected utility is
A) a.
B) b.
C) c.
D) d.
Answer: A

3) The above figure shows Bob's utility function. He currently has $100 of wealth, but there is a
50% chance that it could all be stolen. Bob is
A) risk averse.
B) risk neutral.
C) risk loving.
D) risk premium.
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Answer: A

4) The above figure shows Bob's utility function. He currently has $100 of wealth, but there is a
50% chance that it could all be stolen. Bob's expected wealth is
A) $0.
B) $50.
C) $75.
D) $100.
Answer: B

5) The above figure shows Bob's utility function. He currently has $100 of wealth, but there is a
50% chance that it could all be stolen. To reduce the chance of theft to zero, Bob is willing to pay
A) $20.
B) $50.
C) $70.
D) $80.
Answer: C

6) The above figure shows Bob's utility function. He currently has $100 of wealth, but there is a
50% chance that it could all be stolen. Over and above the price of fair insurance, what is the risk
premium Bob would pay to eliminate the chance of theft?
A) $0
B) $20
C) $30
D) $50
Answer: B

7) The above figure shows Bob's utility function. He currently has $100 of wealth, but there is a
50% chance that it could all be stolen. Living with this risk gives Bob the same expected utility
as if there was no chance of theft and his wealth was
A) $0.
B) $20.
C) $30.
D) $50.
Answer: C

8) The above figure shows Bob's utility function. He currently has $100 of wealth, but there is a
50% chance that it could all be stolen. What is the most Bob would pay for insurance that would
replace his $100 should it be stolen?
A) $30
B) $50
C) $70
D) $75
Answer: C

9) The above figure shows Bob's utility function. He currently has $100 of wealth, but there is a
50% chance that it could all be stolen. If Bob could keep $50 with certainty, his utility would be
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A) a.
B) b.
C) c.
D) d.
Answer: B

10) The above figure shows Bob's utility function. He currently has $100 of wealth, but there is a
50% chance that it could all be stolen. Bob is risk averse because
A) his utility function is concave.
B) he has diminishing marginal utility of wealth.
C) he is willing to pay a premium to avoid a risky situation.
D) All of the above.
Answer: D

11) The above figure shows Bob's utility function. He currently has $100 of wealth, but there is a
50% chance that it could all be stolen. Bob is risk averse because
A) his utility function is convex.
B) he has negative marginal utility of wealth.
C) he is willing to pay a premium to avoid a risky situation.
D) All of the above.
Answer: C

12) The above figure shows Bob's utility function. He currently has $100 of wealth, but there is a
50% chance that it could all be stolen. Bob will buy theft insurance to cover the full $100
A) as long as it does not cost more than $25.
B) as long as it does not cost more than $50.
C) as long as it does not cost more than $70.
D) at any price.
Answer: C

13) If a person is entertained by gambling, then

A) she is not risk averse.
B) she does not understand the concept of a fair game.
C) she may gamble even if it is an unfair game.
D) she will definitely not buy automobile insurance.
Answer: C

14) A risk-preferring person is willing to pay

A) a risk premium.
B) a fee to make a fair bet.
C) to obtain decreasing marginal utility.
D) None of the above.
Answer: B

15) If a person is risk neutral, then she

A) is indifferent about playing a fair game.
B) will pay a premium to avoid a fair game.
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C) has a horizontal utility function.
D) has zero marginal utility of wealth.
Answer: A

16) For a risk-neutral person, the expected utility associated with various levels of wealth
A) is above the person's utility function.
B) is below the person's utility function.
C) is equal to the person's utility function.
D) does not exist.
Answer: C

17) Which of the following games involving the roll of a single die is a fair bet?
A) Bet $1 and receive $1 if 3 or 4 comes up.
B) Bet $1 and receive $1 if 3, 4, or 5 comes up.
C) Bet $1 and receive $4 if six comes up.
D) None of the bets is a fair bet.
Answer: B

18) John derives more utility from having $1,000 than from having $100. From this, we can
conclude that John
A) is risk averse.
B) is risk loving.
C) is risk neutral.
D) has a positive marginal utility of wealth.
Answer: D

19) John's utility from an additional dollar increases more when he has $1,000 than when he has
$10,000. From this, we can conclude that John
A) is risk averse.
B) is risk loving.
C) is risk neutral.
D) has a negative marginal utility of wealth.
Answer: A

20) Bob invests $50 in an investment that has a 50% chance of being worth $100 and a 50%
chance of being worth $0. From this information we can conclude that Bob is NOT
A) risk loving.
B) risk neutral.
C) risk averse.
D) rational.
Answer: C

21) Bob invests $75 in an investment that has a 50% chance of being worth $100 and a 50%
chance of being worth $0. From this information we can conclude that Bob is
A) risk loving.
B) risk neutral.
C) risk averse.
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D) irrational.
Answer: A

22) Catherine is risk averse. When faced with a choice between a gamble and a certain level of
wealth, she will
A) always prefer the gamble.
B) always prefer the certain level of wealth.
C) prefer the gamble if the expected utility from it is higher than the utility from the certain level
of wealth.
D) prefer the certain level of wealth if the expected utility from the gamble is higher than the
utility of the certain level of wealth.
Answer: C

23) Bob invests $25 in an investment that has a 50% chance of being worth $100 and a 50%
chance of being worth $0. From this information we can conclude that Bob is
A) risk loving.
B) risk neutral.
C) risk averse.
D) Any one of the three above.
Answer: D

24) The Friedman-Savage utility function can explain why

A) people buy automobile insurance.
B) somebody becomes addicted to gambling.
C) people become more risk averse as their wealth increases.
D) people place small bets to have a chance at winning a large amount.
Answer: D

25) The Arrow-Pratt measure of risk aversion is

A) negative if a person is risk averse.
B) greater than one if a person is risk averse.
C) negative if a person is risk loving.
D) None of the above.
Answer: C

26) If Ann's utility function is U = W0.5, and she invests in a business which can yield $6,400
with probability 1/5, and $3600 with probability 4/5, then her expected utility is
A) 80.
B) 76.
C) 64.
D) 60.
Answer: C

27) If Ann's utility function is U = W0.5, and she invests in a business which can yield $6,400
with probability 1/5, and $3600 with probability 4/5, then her expected wealth is
A) $1280.
B) $2880.
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C) $4160.
D) $5840.
Answer: C

28) If Ann's utility function is U = W0.5, and she invests in a business which can yield $6,400
with probability 1/5, and $3600 with probability 4/5, then her risk premium to avoid bearing this
risk is
A) $36.
B) $41.6.
C) $64.
D) $100.
Answer: A

29) If Ann's utility function is U = 3W0.5, and she invests in a business which can yield $6,400
with probability 1/5, and $3600 with probability 4/5, then her Arrow-Pratt measure of risk
aversion is
A) 0.5/w.
B) 1/w.
C) 1.5w.
D) 3/w.
Answer: A

33) Johnny owns a house that would cost $100,000 to replace should it ever be destroyed by fire.
There is a 0.1% chance that the house could be destroyed during the course of a year. Johnny's
utility function is U = W0.5. How much would fair insurance cost that completely replaces the
house if destroyed by fire? Assuming that Johnny has no other wealth, how much would Johnny
be willing to pay for such an insurance policy? Why the difference?
Answer: Fair insurance would cost (0.001 ∗ $100,000) = $100. Johnny's expected utility without
insurance equals (.001 ∗ 00.5) + (.999 ∗ 100,0000.5) = 315.91. He can receive this level of utility
with certainty if he had risk-free wealth of $99,800.10. Thus he is willing to pay $199.90 for
insurance. He is willing to pay more than the fair price because he is risk averse.

34) For the utility function U = Wa, what values of "a" correspond to being risk averse, risk
neutral, and risk loving?
Answer:
0 < a < 1 implies risk averse.
a = 1 implies risk neutral.
a > 1 implies risk loving.

35) What type of risk behavior does the person exhibit who is willing to pay $5 for the chance to
bet $60 on a game where 20% of the time the bet returns $100, and 80% of the time returns $50?
Explain.
Answer: This person is risk preferring. The bet is fair. The expected wealth of the person is the
same whether or not the bet is made. However, this person is willing to pay $5 to make this fair
bet.

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36) Describe how the risk premium for a person with a convex utility function is determined.
Answer: A person with a convex utility function is risk preferring. This person will not pay a
premium to avoid risk. The risk premium is zero.

37) Bob's utility function is shown in the above Figure. He currently has $100 worth of property,
but there is a 50% chance that all of it will be stolen. An insurance company offers to reimburse
Bob for his loss if the money is stolen. What is the most that Bob would pay for such a policy?
Explain.
Answer: A risky life leaves Bob with expected utility that could be had from a certain $30. Thus
he is willing to part with $70 to insure himself against such a loss.

39) Stephan has the utility function U(w) = 3 , where w is his wealth. Initially, Stephan has
w = $100. Would Stephan pay $5 to take the following gamble: With probability 0.03 he wins
$25; otherwise, he wins nothing.
Answer: Stephan's expected utility from the lottery (accounting for the $5 cost to play) is:
EU(L) = 0.97 ∗ U(100 - 5) + 0.03 ∗ U(100 + 25 - 5) = 29.35
If he does not take the lottery, he will get U(100) = 30. The lottery provides less utility and he
will therefore not take the risk.

40) Cindy's attitudes towards risk are summarized by the utility function U(w) = . Cindy has
an initial wealth of $100. There is a 10% chance that her home will sustain flood damage next
year costing her $40 in repairs. What is the most she will pay to for a full $40 of flood insurance?
Answer: Without insurance, Cindy's expected utility is:
EU = 0.90 U(100) + 0.10 U(60) = 29.32
She will pay a maximum of X where:
U(100 - X) = 29.32
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Solving for X = 4.56.

41) For each of the following statements, state whether the statement is true, false, or uncertain
and explain why.
i. A risk neutral person is indifferent to a gamble and the expected value of the gamble.
ii. A risk-averse person will never accept a gamble.
iii. A risk-loving person will accept any gamble.
Answer:
i. True, the expected utility of a gamble equals the utility of the expected value for a R.N.
individual.
ii. False, a risk averse person will not accept a "fair" gamble (or worse) but *may* accept a
gamble with a positive expected value.
iii. False, a risk loving individual will accept any fair gamble, but if the expected value is
sufficiently negative, they will not accept the gamble.
Topic: Attitudes Toward Risk
Skill: Analytical thinking
Status: Old

42) Bob has an initial wealth of $1200 but faces a 50% chance of losing $800 to doctors' bills in
the coming year. Insurance is available at a rate of 60¢ per $1 of coverage. This means that if
Bob purchases $X in coverage, it costs 6X¢ and pays $X towards Bob's doctors' bills. If Bob's
utility function is U(w) = 2 , how much insurance (X) will Bob purchase?
Answer: We can write out Bob's expected utility as a function of his coverage amount:
EU = .5U(1200 - .6B) + .5U(400 + X - 0.6X)
The optimal X is found by taking the derivative of the EU expression w.r.t X:
dEU/dX = -0.3(1200 - 0.6X)-0.5 +0.2(400 + 0.4X)-0.5 = 0
Solving yields X = 200.

43) An individual has an initial wealth of $35,000 and might incur a loss of $10,000 with
probability p. Insurance is available that charges $gK to purchase $K of coverage. What value of
g will make the insurance actuarially fair? If she is risk averse and insurance is fair, what is the
optimal amount of coverage?
Answer:
The insurance company's expected payoff is:
p(gK – K) + (1 – p)(gK)
Fair insurance requires:
p(gK – K) + (1 – p)(gK)=0
Which means the g = p
If she is risk averse, she will purchase full coverage (K = 10,000). Formally, she will choose K to
maximize her expected utility:
EU = p*U(25,000 + (1 – p)K) + (1 – p)*U(35,000 – pK)
The Necessary Condition for Maximum is:
U'(25000 + (1 - p)K) = U'(35,000 – pK)
which requires that:
25000 + (1 – p)K = 35000 – pK.
Solving yields K = 10,000.
For this to be a maximum (not a minimum), the expected utility function must be concave, which
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is assured from the fact that the utility function is concave (risk averse).

44) A deductible is an amount of a claim not covered by insurance. A deductible is a fixed

portion of the accident cost that the insured person must pay in order to make a claim to their
insurer (this is similar to a co-pay in which you must pay a portion of the medical costs in the
case you get sick). For example, if I break my arm, I have to pay a $50 deductible to the
insurance company in order to get them to cover the rest of my medical costs from the accident.

Rosa has a 10% chance of getting sick in the next year. If she gets sick, her medical bills will
amount to $500. She has a wealth of $1,000. Suppose she has the utility function U(X) = X0.5
where x is her net wealth at the end of the year.

Suppose Rosa can purchase insurance. The insurance company provides two plans for Rosa to
select from, both providing $500 of coverage in the case that Rosa gets hurt. Plan A has zero
deductibles (good!) but charges a high premium (bad!). Specifically, Plan A charges $55 for $500
of coverage. Plan B has a deductible of $K, where K < 500, but charges a premium of just $(55
– .11K).
a. Suppose K = $100. Will Rosa purchase insurance and if so, which plan? Show this
mathematically.
b. If Rosa can choose the deductible, K, what amount of deductible will she choose?
c. Suppose Rosa knows her chance of getting sick is really just 5%. How will this affect the
deductible she chooses? You only need to provide intuition (in words) for this part, not explicit
computation.
Answer:
a. Rosa's expected utility from the various plans are:
EU(no insurance) = 0.10U(500) + 0.90U(1000) = 30.70
(Plan A) = U(1000 – 55) = 30.74
EU(Plan B) = 0.10U(1000 – 100 – 55 + 11) + 0.90U(1000 – 44) = 30.75
She will go for Plan B.
b. Her expected utility as a function of K:
EU(K) = 0.10U(1000 – K – 55 + 0.11K) + 0.90 U(1000 – 55 + 0.11K)
The derivative of this w.r.t. K is:
–0.0445/(945–0.89K)0.5 + 0.0495/(945 + 0.11K)0.5 = 0
Solving for K
0.8082(945 + 0.11K) = (945 – 0.89K)
K = 177.75.
c. If she knows she has a lower chance of getting sick, she will favor a larger deductible at a
higher premium. This is because increasing the deductible is only costly to her 5% of the time,
where she has to pay the premium all of the time.

45) Sarah has the utility function U(x) = 1 - 1/x, where x is the present value of her lifetime
income. Sarah is trying to select a career. If she goes into teaching, she will make x=5 with
certainty. If she pursues acting, she will make x=400 if successful or x=2 if unsuccessful (and
therefore ends up waiting tables). The chance of succeeding in acting is 1% if she pursues acting.
a. Determine which career Sarah will choose. Is she choosing the career with the higher
expected value? Explain.
b. An acting career expert charges 0.01 to determine if a person will succeed at acting. By going
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to an expert, Sarah can choose the best career according to her skills. Assuming that the expert is
able to correctly determine if Sarah will be a successful actor, will she pay for this service?
Answer:
a. Sarah's expected utility from each career is:
EU(teaching) = U(5) = 0.80
EU(acting) = 0.01 U(400) + 0.99 U(2) = 0.55
She prefers to take the less risky career teaching. The EV's are:
EV(teaching) = 5
EV(acting) = 0.01(400) + 0.99(2) = 5.98
Acting has a higher EV, but because it is more risky she pursues teaching.
b. If she goes to the expert and learns that she will not succeed at acting, she will change to
teaching. Her expected utility from not going to the expert is 0.80 (*she will become a teacher as
we found in a.). Her expected utility from seeing the expert is:
EU(expert) = 0.01 U(400 – 0.01) + 0.99 U(5 – 0.01) = .802 > .800
She will go with the expert.

46) Derive the Arrow-Pratt measure of risk aversion for the following utility functions. Which
represents the greatest level of risk aversion according to the measure?
a. U(X) =
b. U(X) = -e-x
c. U(X) = 1 - 1/X
Answer:
a. U'(X) = .5/X.5, U''(X) = -.25/X1.5, so ρ(X) = .5/X
b. U'(X) = e-x, U"(X) = -e-x, so ρ(X) = 1.
c. U'(X) = 1/X2, U"(X) = -2/X3, so ρ(X) = 2/X

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