Practice Question_Chap 16

# Practice Question_Chap 16 - Uncertainty and Consumer...

This preview shows pages 1–3. Sign up to view the full content.

Uncertainty and Consumer Behavior Suppose   that   two   investments   have   the   same   three   payoffs,   but   the  probability associated with each payoff differs, as illustrated in the table  below: Payoff    Probabilities for Investment A Probabilities for Investment B \$300 0.10 0.30 \$250 0.80 0.40 \$200 0.10 0.30 a. Find the expected return and standard deviation of each investment. The expected value of the return on investment A is EV  = (0.1)(300) + (0.8)(250) + (0.1)(200) = \$250. The variance on investment A is σ 2  = (0.1)(300 - 250) 2  + (0.8)(250 - 250) 2  + (0.1)(200 - 250) 2  = \$500. The expected value of the return on  investment B is EV  = (0.3)(300) + (0.4)(250) + (0.3)(200) = \$250. The variance on investment B is σ 2  = (0.3)(300 - 250) 2  + (0.4)(250 - 250) 2  + (0.3)(200 - 250) 2  = \$1,500. b. Jill has the utility function   U = 5 I , where I denotes the payoff.   Which  investment will she choose? Jill’s expected utility from investment A is EU=.1*(5*300)+.8*(5*250)+.1*(5*200)=1,250. Jill’s expected utility from investment B is EU=.3*(5*300)+.4*(5*250)+.3*(5*200)=1,250. Since both investments give Jill the same expected utility she will be  indifferent between the two. c. Ken has the utility function  U = 5 I .  Which investment will he choose? Ken’s expected utility from investment A is EU=.1*(5*300) 0.5 +.8*(5*250) 0.5 +.1*(5*200) 0.5 =35.32. Ken’s expected utility from investment B is

This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document
EU=.3*(5*300) 0.5 +.4*(5*250) 0.5 +.3*(5*200) 0.5 =35.25. Ken will choose investment A since it has a higher expected utility.  Notice  that since Ken is risk averse, he will prefer the investment with less  variability. d. Laura has the utility function  U = 5 I 2 .  Which investment will she choose? Laura’s expected utility from investment A is EU=.1*(5*300*300)+.8*(5*250*250)+.1*(5*200*200)=315,000. Laura’s expected utility from investment B is
This is the end of the preview. Sign up to access the rest of the document.

## This note was uploaded on 02/13/2012 for the course ECON 121 taught by Professor Adam during the Spring '11 term at Bunker Hill.

### Page1 / 6

Practice Question_Chap 16 - Uncertainty and Consumer...

This preview shows document pages 1 - 3. Sign up to view the full document.

View Full Document
Ask a homework question - tutors are online