Problem Set #3
Micro II – Spring Term 2010
Instructor: Gul Andaman
Wednesday, March 24, In the first slot
1. Suppose that Natasha’s utility function is given by
, where I represents
annual income in thousands of dollars.
Is Natasha risk loving, risk neutral, or risk averse? Explain.
Suppose that Natasha is currently earning an income of $40,000 (
= 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?
In (b), would Natasha be willing to buy insurance to protect against the variable
income associated with the new job? If so, how much would she be willing to pay
for that insurance? (Hint: What is the risk premium?)
2. As the owner of a family farm whose wealth is $250,000, you must choose between
sitting this season out and investing last year’s earnings ($200,000) in a safe money market
fund paying 5.0% or planting summer corn. Planting costs $200,000, with a six-month
time to harvest. If there is rain, planting summer corn will yield $500,000 in revenues at
harvest. If there is a drought, planting will yield $50,000 in revenues at harvest. As a third
choice, you can purchase AgriCorp drought-resistant summer corn at a cost of $250,000
that will yield $500,000 in revenues at harvest if there is rain, and $350,000 in revenues at