Practice problems

1. Suppose that Natashas utility function is given by u(I) 10I , where I represents annual income in thousands of
dollars.
a. Is Natasha risk loving, risk neutral, or risk averse? Explain.
b. Suppose that Natasha is currently earning an income of $40,000 (I = 40) and can earn that income next year with
certainty. She is offered a chance to take a new job that offers a .6 probability of earning $44,000 and a .4
probability of earning $33,000. Should she take the new job?
Note that Income I is measured in 000.
Solution: Natasha is Risk Averse. Risk Averse individuals have diminishing Marginal utility of wealth. This implies
that the second order derivative with respect to wealth must be <0.
2 U
2
= 10 I 3 /2 <0
I
(b) EU(job) > U(certain income) for Natasha to take up the job. In this case, EU(job)=
0.6 1044+0.4 1033=19.85
Which is less than U(40) =20. Hence she will not take up the job.

2. Buck Columbus is thinking of starting a pinball palace near a large Midwestern university. Buck is an expected
utility maximizer with a von Neuman-Morgenstern utility function, U(W) = 1 ( ), where W is his
wealth. Bucks total wealth is $12,000. With probability .2 the palace will be a failure and hell lose $9,000, so
that his wealth will be just $3,000. With probability .8 it will succeed and his wealth will grow to $ x. What is the
smallest value of x that would be sufficient to make Buck want to invest in the pinball palace rather than have a
wealth of $12,000 with certainty?
Solution:

We want to find the minimum income above which Expected utility from palace is greater than Utility from
certain wealth.

U(12000) EU(Palace). From the Expected utility function, solve for x.

3. Joes wealth is $100 and he is an expected utility maximizer with a von Neumann-Morgenstern utility function

Joe is afraid of oversleeping his economics exam. He figures there is only a 1 in 10 chance that he
will, but if he does, it will cost him $100 in fees to the university for taking an exam late. Joes neighbor, Mary,
never oversleeps. She offers to wake him one hour before the test, but he must pay her for this service. What is the
most that Joe would be willing to pay for this wake-up service?

4. A person has an expected utility function of the form . He initially has wealth of $4. He has a
lottery ticket that will be worth $12 with probability 1/2 and will be worth $0 with probability 1/2. What is his
expected utility? What is the lowest price p at which he would part with the ticket?
5. Socrates owns just one ship. The ship is worth $200 million dollars. If the ship sinks, Socrates loses $200 million.
The probability that it will sink is .02. Socrates total wealth including the value of the ship is $225 million. He is

an expected utility maximizer with von Neuman-Morgenstern utility What is the maximum amount
that Socrates would be willing to pay in order to be fully insured against the risk of losing his ship