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Unformatted text preview: Econ 131 Fall Quarter 2009 Problem Set #4 Answer Key 1) Straightforward.... 2) Tom and Lindsey just began working for a used car dealer. They both must decide on one of two pay options. Option #1 pays a guaranteed rate of $200,000/year. Option #2 pays $10,000/year half of the time and $490,000/year the other half of the time. Assume Lindsey's utility she derives from her wage is given by and assume Tom's utility he derives from his wage is given by a. What is Lindsey's expected wage if she chooses option #1? If she chooses option #2? b. What is Tom's expected wage if he chooses option #1? If he chooses option #2? c. What is Lindsey's expected utility if she chooses option #1? If she chooses option #2? d. What is Tom's expected utility if he chooses option #1? If he chooses option #2? e. Which payment option would Lindsey choose? Which would Tom choose? Lindsey would choose option #2. Tom would choose option #1. f. How high would the option #1 payment have to be in order for Lindsey to choose option #1? Option #1 would have to pay at least $50,000 more (greater than or equal to $250,000) for Lindsey to find it optimal to choose option #1. g. What is the lowest payment in for option #1 that Tom would accept before switching to payment option #2? . Tom would stick with option #1 as long as the utility he would receive with certainty from option #1 is greater than the expected utility of option #2. Therefore, the wage in option #1 would have to fall below $160,000 (with certainty) for Tom to be willing to take the risk and choose payment plan #2. 3) A small city on the Gulf of Mexico is considering building a boardwalk along the waterfront. In order to build the walkway, a large area of wetlands along the waterfront would have to be filled in. It is pointed out that the wetlands provide a natural buffer to storm surges that commonly strike the Gulf Coast. By comparing historical damage costs in nearby cities (without wetlands) to damage costs in their own city from past storms, officials estimate that on average the wetlands reduce storm costs by $10 million/year. How should this information be used in a cost benefit analysis of the proposed boardwalk? Would the proposed boardwalk be more likely to pass if society is risk neutral or risk averse? The reduction in expected damages is a benefit provided by the wetlands. Therefore, in a cost benefit analysis of removing the wetlands and building a boardwalk, the lost damage reduction potential is a cost. If we assume the citizens of the city are risk neutral, then the cost would exactly equal $10 million/year. However, if the citizens are risk averse, the cost of removing the wetlands will be greater than $10 million/year. The proposed boardwalk would be more likely to pass if the citizens are risk neutral. 4) to be added..... ...
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This note was uploaded on 12/09/2009 for the course ECON 131 taught by Professor Groves during the Fall '09 term at UCSD.
- Fall '09
- Environmental Economics