Winter 2008 - Newhouse's Class - Exam 2 (Version B)

# Winter 2008 - Newhouse's Class - Exam 2 (Version B) -...

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Economics 171: Decisions Under Uncertainty Midterm 2 – Solutions – Winter 2008 1. (25 pts) Joe’s utility function is 1 4 4 u x = . a. Calculate Joe’s coefficient of absolute risk aversion. 3 7 4 4 7 4 1 3 4 3 ' , '' 4 3 '' 3 4 ' 4 u x u x x u x u x λ = = − = − = − = b. Find Joe’s certainty equivalent for lottery p = (\$1, 0.6; \$81, 0.4). ( ) ( ) ( ) ( ) 1 1 1 4 4 4 1 4 1 4 4 0.6 4 1 0.4 4 81 4 7.2 1.8 \$10.5 u x EU p x x x x = = + = = c. Find Joe’s risk premium for lottery p = (\$1, 0.6; \$81, 0.4). ( ) ( ) ( ) ( ) ( ) ( ) 0.6 1 0.4 81 33 33 10.5 \$22.5 E p R p E p CE p = + = = = = d. Bill is at least as risk averse as Joe. What’s the most that can be said about Bill’s risk premium for lottery p = (\$1, 0.6; \$81, 0.4). \$22.5 B R

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