Risk and Uncertainity Solution

Economics of Uncertainty and Information Timoihy Van Zandi
Augusi 2006
Chapter 1
Introductionto decision theory
SOLUTIONS TOEXERCISES
Augusi 2006
Chapter 2
Lotteries and objective expected utility
Exercise 2.1. Considei ihe paiis of loiieiies in Figuies E2.1 and E2.2.
Figure E2.1
I
Hoboken
I
4
London
3
4
II
NYC
I
4
San Fran
I
4
London
I
2
Figure E2.2
III
Hoboken
I
6
San Fran
2
3
London
I
6
IV
NYC
I
6
San Fran
3
6
Show ihaiio be consisieni wiih ihe Independence Axiomif I is chosen ovei II ihen III should
be chosen ovei IV.
SoiU1io: Te compound loiieiies in Figuies S1 and S2 aie equivaleni io ihe sim-
ple loiieiies shown in Figuies E2.1 and E2.2, iespeciively.
Figure S1
I
London
I
2
I
2
Hoboken
I
2
London
I
2
II
London
I
2
I
2
NYC
I
2
San Fran
I
2
Solutions for Chapter 2 (Lotteries and objective expectedutility) 2
Figure S2
III
San Fran
2
3
I
3
Hoboken
I
2
London
I
2
IV
San Fran
2
3
I
3
NYC
I
2
San Fran
I
2
Accoiding io ihe Independence Axiom, ihe piefeiences ovei I vs. II and ovei
III vs. IV aie deieimined by ihe piefeiences ovei ihe iwo loiieiies in Figuie S3.
Figure S3
P
Hoboken
I
2
London
I
2
Q
NYC
I
2
San Fran
I
2
Hence, if I is chosen ovei II, ihen III should be chosen ovei IV.
Introduction to the Economics of Uncertainty and Information
Heie is how I came up wiih ihe decomposiiion of ihe simple loiieiies inio ihe
compound loiieiies shown above. We aie solving foi loiieiies P, Q, R and S and
piobabiliiies and so ihai ihe simple loiieiies aie equivaleni io ihe compound
loiieiies shown in Figuie 3 on page 13 of ihe leciuie noies. Fiisi we deieimine a
maximal sei of possible ouicomes foi each loiieiy. Foi example, an ouicome can be
possible foi loiieiy P only if ii is possible in boih I and III. Tis yields:
Loiieiy Possible Ouicomes
P Hoboken, London
Q NYC, San Fian
R London
S San Fian
Given ihai ihe piobabiliiies foi each of ihese loiieiies sum io 1, we have ihai
R(London) = I and S(San Fian) = I. We aie lef io nd P(Hoboken), Q(NYC),
and . Each of ihese can be deieimined by ihe iesiiiciion ihai ihe compound
loiieiies ieduce io ihe coiiesponding simple loiieiies. Foi example, since:
Q(London) + (I )R(London) = II(London)
II(London) = I/2
Q(London) = 0
R(London) = I
we can conclude ihai = I/2. Similaily,
P(Hoboken) + (I )R(Hoboken) = I(Hoboken)
I(Hoboken) = I/4
R(Hoboken) = 0
= I/2
= P(Hoboken) = I/2.
P(San Fian) + (I )S(San Fian) = III(San Fian)
III(San Fian) = 2/3
P(San Fian) = 0
S(San Fian) = I
= = I/3
Q(NYC) + (I )S(NYC) = IV(NYC)
IV(NYC) = I/6
S(NYC) = 0
= I/3
= Q(NYC) = I/2.
Exercise 2.2. A decision makei has maximin piefeiences ovei loiieiies if, foi some ianking of oui-
comes, ihe decision makei chooses ihe loiieiy whose woisi possible ouicome is ihe besi.
Tis is noi a compleie deniiion, because ii does noi say how ihe decision makei ianks iwo loiieiies
when indieieni beiween iheii woisi possible ouicomes. Teie aie vaiious ways io compleie ihe deni-
iion, bui a simple one ihai will suce foi ihe puipose of ihis exeicise is io assume ihai ihe decision makei
is ihen indieieni beiween ihe iwo loiieiies. (Te alieinaiive is io desciibe moie complicaied iules foi
bieaking ihis indieience, such as looking ai ihe second-woisi ouicome oi looking ai ihe piobabiliiy
placed on ihe common woisi ouicome.)
a. Lei be a iaiional piefeience oideiing on ihe sei L of loiieiies on a sei X. Lei each elemeni x of
X also denoie ihe loiieiy ihai puis piobabiliiy 1 on x, so ihai also is an oideiing on X. Wiih ihis
noiaiion in mind, siaie foimally whai ii means foi io be maximin piefeiences.
SoiU1io: Teie aie vaiious ways. Heie is ihe mosi succinci one ihai I can ihink
of.
aie maximin piefeiences if ihe following holds. Foi all loiieiies P, Q L,
P Q if and only if, foi all x X such ihai P(x) > 0, iheie is x
X such
ihai Q(x
) > 0 and x x
.
b. Show ihai maximin piefeiences violaie ihe Independence Axiom. (You will need a minoi auxiliaiy
assumpiion.)
SoiU1io: Suppose iheie aie iwo ouicomes x
I
and x
2
such ihai x
I
x
2
. (Tis is
ihe minoi auxiliaiy assumpiion.) Lei P and Q be ihe loiieiies ihai pui piobabiliiy
1 on x
I
and x
2
, iespeciively. Ten P Q bui 0.3P + 0.3Q 0.3Q + 0.3Q.
Noie: In my pioof, Q plays ihe iole of boih Q and R in ihe deniiion I gave of
ihe independence axiom. Many of you gave insiead ihe following pioof, which is
also coiieci bui which iequiies a siiongei auxiliaiy assumpiion:
Suppose X coniains ihiee elemenis x
I
, x
2
and x
3
such ihai
x
I
x
2
x
3
.
Lei P, Q, and R be ihe loiieiies ihai place piobabiliiy 1 on x
I
, x
2
, and x
3
, iespec-
iively. Ten P Q bui
.3P + .3R .3Q + .3R.
Exercise 2.3. Lei be a siiici piefeience ielaiion ovei a sei P of loiieiies. Suppose ihai saiises
ihe following:
(Axiom 1) If p q, ihen foi all a (0, I) and r P ii follows ihai
ap + (I a)r aq + (I a)r. (E2.1)
Show ihai also saiises ihe following:
(Axiom 2) If p q and a, b (0, I) aie such ihai a > b, ihen
ap + (I a)q bp + (I b)q. (E2.2)
SoiU1io: If I had asked you io show ihis foi a specic example, no one would
have had any pioblem. Te geneial pioof is ihe same, bui wiih symbols meani io
iepieseni any loiieiy. Howevei, ii is noi so easy io gei used io ihinking absiiacily.
Lei p and q be loiieiies such ihai p q and lei and be numbeis beiween 0
and 1 such ihai > . Using ihe Independence Axiom (Axiom 1), we have io show
ihai
p + (I )q p + (I )q.
When applying ihe IA, ii is impoiiani io iemembei ihai ihe symbols in ihe axiom
aie meani io iepieseni any loiieiies oi numbeis, noi simply ihe loiieiies oi numbeis
we have wiiiien down so fai.
We wani io nd numbeis a and such ihai I = p + (I )q and I I =
p + (I )q, as illusiiaied in Figuie S4.
Figure S4
I
I a
p
q
I
p
a
II
I a
p
q
I
q
a
If we can, ihen, since ihe lef bianches of loiieiies I and II aie boih ihe same, I
II if p q.
I is equivaleni io ihe loiieiy ((I a) + a)p + (I a)(I )q. Ten I =
p+(I )q if (I a) +a = . II is equivaleni io (I a)p+((I a)(I ) +a)q.
Ten II = p + (I )q if (I a) = . Te soluiion io ihese iwo equaiions is
a = and = /(I + ).
Exercise 2.4. You aie going io have pizza foi dinnei, and aie iiying io decide wheihei io have io
pizza deliveied, oi wheihei io pick ii up youiself. In ihe end, all ihai maiieis io you is how much ihe
pizza cosis and wheihei ihe pizza is hoi oi cold (e.g., ihe iiip io ihe pailoi is iiielevani). Te pizza cosis
$10. If ii is deliveied, you pay a $2 deliveiy chaige, unless ihe pizza is cold when ii aiiives, in which case
ihe pizza and ihe deliveiy aie fiee. Te pizza pailoi deliveis cold pizza 1 oui of 30 iimes. If you decide
io pick ihe pizza up, iheie is no deliveiy chaige. Howevei, iheie is a 1 in 10 chance ihai you will be laie
and ihe pizza will be cold. Teie is also a 1 in 100 chance (independeni of wheihei you aie laie) ihai you
will be ihe 200ih cusiomei io go inio ihe pizzeiia ioday, in which case ihe pizza is fiee.
a. Wiiie youi decision as a choice beiween iwo loiieiies.
SoiU1io: Poieniial ouicomes aie dened by wheihei pizza is hoi oi cold and
how much ii cosis. Lei, foi example, cold/$10 be ihe ouicome wheie ihe pizza is
cold and cosis $10.
Loiieiy when pizza is deliveied (loiieiy p):
Piobabiliiy Ouicome
49/30 Hoi/$12
1/30 Cold/$0
Loiieiy when you pick ihe pizza up (loiieiy q):
Piobabiliiy Ouicome
891/1000 Hoi/$10
9/1000 Hoi/$0
99/1000 Cold/$10
1/1000 Cold/$0
b. If I only know ihai you like hoi pizza moie ihan cold pizza (oihei ihings equal) and cheap pizza
moie ihan expensive pizza (oihei ihings equal), can I deieimine youi ianking of ihe possible ouicomes
in ihe iwo loiieiies: (Explain.)
SoiU1io: No. Foi example, I cannoi knowwheihei you piefei Cold/$0 oi Hoi/$10.
c. Is iheie any ianking of ihe ouicomes consisieni wiih ihe above (hoi beiiei ihan cold, eic) such ihai
having ihe pizza deliveied isi-oidei siochasiically dominaies picking up ihe pizza: (Explain.)
SoiU1io: No. Te besi possible ouicome when picking up ihe pizza (Hoi/$0) is
siiicily piefeiied io any possible ouicome when ihe pizza is deliveied.
d. Give a ianking of ihe ouicomes consisieni wiih ihe above such ihai picking ihe pizza up isi-oidei
siochasiically dominaies having ihe pizza deliveied.
SoiU1io: Hoi/$0 Hoi/$10 Cold/$0 Cold/$10 Hoi/$12.
You did noi have io wiiie ihis iable oui, bui heie ii is:
z p(z z) q(z z)
Hoi/$12 49/30 0
Cold/$10 49/30 99/I000
Cold/$0 I I/I0
Hoi/$10 I 99I/I000
Hoi/$0 I I
e. Give a ianking of ihe ouicomes consisieni wiih ihe above such ihai picking ihe pizza up does noi
isi-oidei siochasiically dominaie having ihe pizza deliveied.
SoiU1io: Hoi/$0 Hoi/$10 Hoi/$12 Cold/$0 Cold/$10.
z p(z z) q(z z)
Cold/$10 0 99/I000
Cold/$0 I/30 I/I0
Hoi/$12 I I/I0
Hoi/$10 I 99I/I000
Hoi/$0 I I
Exercise 2.5. Lei Z be a niie sei of money values, and lei p and q be loiieiies on Z. Show ihai ihe
following aie equivaleni:
1. Foi all z Z: p(z z) q(z z).
2. Foi all z Z: p(z z) q(z z).
SoiU1io: We have io show ihai I 2 and 2 I. Heie is ihe pioof of I 2.
Te pioof of 2 I is ihe same, bui wiih ihe inequaliiies ieveised.
Assume 1 is iiue. Lei z Z. We have io show ihai p(z z) q(z z).
If z is ihe smallesi value in Z, ihen p(z z) = q(z z) =. If z is not ihe
smallesi value in Z, ihen ihe sei of values in Z smallei ihan z has a laigesi elemeni
z. Fiom piopeiiy 1,
p(z z) q(z z). (S1)
_
z Z | z z
_
and
_
z Z | z z
_
. aie disjoini seis whose union is Z. Teie-
foie, ihe sum of ihe piobabiliiies of ihese iwo evenis is 1. Ten we can ieplace
p(z z) in (S1) by I p(z z) (and similaily foi q):
I p(z z) I q(z z) (S2)
p(z z) q(z z). (S3)
Exercise 2.6. Suppose ihai you aie consideiing insuiing a piece of luggage. Given ihe iisks and
ihe insuiance piemium quoied, you decide ihai you aie indieieni beiween geiiing and noi geiiing ihe
insuiance. Ten ihe aiiline oeis you a piobabilisiic insuiance policy. You pay ihe piemium, as usual.
If ihe luggage is losi, ihen wiih piobabiliiy 1/2 you ieceive ihe value of ihe luggage, and wiih piobabiliiy
1/2 youi piemium is insiead ieiuined io you.
Suppose ihai youi piefeiences saiisfy ihe Independence Axiom. How do you iank ihis piobabilisiic
insuiance compaied io geiiing full insuiance:
Noies and hinis:
1. You should assume ihe piemium is suchihai, if you know you have losi youi luggage ihen you piefei
io be insuied (e.g., ihe piemium is lowei ihan ihe value of ihe luggage).
2. You should answei ihis quesiion diawing iiees and applying ihe IA diiecily, iaihei ihan using a
uiiliiy iepieseniaiion.
3. As you should expeci, you need io siaii by seiiing up ihe sei of ouicomes.
SoiU1io: Geiiing full insuiance is siiicily piefeiied io ihe piobabilisiic policy.
Heie is an explanaiion:
Lei be ihe piobabiliiy of losing youi luggage. Considei ihe following oui-
comes:z
IL You aie insured bui have lost your luggage (i.e., you have losi youi luggage, have
ieceived ihe insuiance paymeni and have paid ihe piemium).
NIL You aie not insured bui have lost your luggage.
PP You have not lost your luggage, bui you aie insuied and have paid the premium.
Ten ihe loiieiies ihai iesuli fiom ihe iwo insuiance policies aie shown in Fig-
uie S3.
Figure S5
(Full insurance)
I
IL
PP
I
(Probabilistic Ins.)
II
NIL
1/2
IL
1/2
PP
I
We aie iiying io show ihai you piefei I io II. By ihe IA, ihis is iiue if and only
if you piefei geiiing ihe ouicome IL foi suie io ihe loiieiy in Figuie S6.
Figure S6
NIL
1/2
IL
1/2
By ihe IA again, ihis is iiue if and only if IL NIL, which we have assumed.
Noie: One can also show ihai, assuming IL NIL, ihen I isi-oidei siochasii-
cally dominaies II.
Exercise 2.7. Recall ihe maximin piefeiences dened in Exeicise 2.2. Show ihai ihese piefeiences
violaie ihe Coniinuiiy Axiom. (You will need a minoi auxiliaiy assumpiion.)
SoiU1io: Suppose X coniains ihiee elemenis x
I
, x
2
, and x
3
such ihai
x
I
x
2
x
3
.
Lei P, Q, and R be ihe loiieiies ihai place piobabiliiy 1 on x
I
, x
2
, and x
3
, iespec-
iively. Ten P Q, bui foi all (0, I),
Q R + (I )P,
wheieas ihe coniinuiiy axiomsiaies ihai iheie is (0, I) suchihai R+(I)P
Q.
Exercise 2.8. Lei be VNM piefeiences ovei loiieiies L, iepiesenied by a VNM uiiliiy funciion
u : Z R. Suppose v : Z R is a posiiive ane iiansfoimaiion of u. Show ihai v also iepiesenis ihe
piefeiences .
SoiU1io: Lei a > 0 and b be such ihai v(z) = au(z) +b. Lei U(P) (iesp., V(P))
be ihe expecied uiiliiy of loiieiy P foi ihe uiiliiy funciion u (iesp., v). Ten, using
ihe faci ihai
zZ
P(z) = I,
V(P) =

zZ
P(z)v(z) =

zZ
P(z)(au(z) + b)
= a

zZ
P(z)u(z) + b

zZ
P(z) = aU(P) + b.
Teiefoie, since a > 0, V(P) V(Q) if and only if U(P) U(Q).
Exercise 2.9. A peison you know (wiih an odd view aboui fun) poinis a ievolvei ai youi head. Ii
has six chambeis and n bulleis. He is going io spin ihe chambeis and pull ihe iiiggei foi suie, bui isi
he makes you an oei. If you give him a ceiiain amouni of money, he will isi iemove one of ihe bulleis.
Mosi people say ihai in such a siiuaiion, ihey would pay moie if iniiially iheie weie a single bullei
ihan if iheie weie foui bulleis. Tai is, iheie is some numbei x of dollais such ihai ihey would agiee io
pay x dollais io iemove ihe bullei if n = I, bui ihey would iefuse io pay x io iemove a bullei if n = 4.
Te puipose of ihis pioblem is io show ihai such choices aie inconsisieni wiih expecied-uiiliiy
maximizaiion, assuming ihai (i) if you suivive, you piefei moie money ovei less money (ii) if you die,
you doni caie how much money you have. Doni confuse ihings by ieading ioo much inio ihe pioblem.
a. Wiihin ihe VNM fiamewoik, whai exacily aie ihe iwo choice pioblems (involving a ioial of foui
alieinaiives): (Be explicii, which doesni mean veibose.)
SoiU1io: Heie aie ihe ouicomes, wiih abbieviaiions:
Live, Pay x = LX Die, Pay x = DX
Live, Pay 0 = L0 Die, Pay 0 = D0
Because ihe peison is indieieni beiween DX and D0, we do noi need io dieien-
iiaie beiween ihese ouicomes. We can ieplace ihem by ihe ouicome Die, denoied
by D.
Te choices, in ieims of aciions, aie PAY and NOT PAY. Lei PAY(n) and
NOT PAY(n) be ihe loiieiies ihese aciions induce when iheie aie iniiially n bulleis:
Figure S7
PAY(1)
LX
1
NOT PAY(1)
L0
3
6
D
I
6
PAY(4)
LX
I
2
D
I
2
NOT PAY(4)
L0
I
3
D
2
3
b. Show diiecily ihai ihe choices violaie ihe Independence Axiom.
SoiU1io: Te dieience beiween PAY(1) and PAY(4) is ihai a 1/2 chance of LX
is ieplaced by a 1/2 chance of D. Te dieience beiween ihe NOT PAY(1) and NOT
PAY(4) is ihai a 1/2 chance of L0 is ieplaced by a 1/2 chance of D. Tis suggesis ihe
following decomposiiion of ihe loiieiies:
Figure S8
PAY(1)
LX
I
2
LX
I
2
NOT PAY(1)
L0
I
2
I
2
L0
2
3
D
I
3
PAY(4)
D
I
2
LX
I
2
NOT PAY(4)
D
I
2
I
2
L0
I
3
D
2
3
Lei PAY(1)
be ihe loiieiy obiained by ieplacing ihe lef-hand bianch of ihe

PAY(1) loiieiy by a 1/2 chance of L0:
Figure S9
PAY(1)
L0
I
2
LX
I
2
Te Independence Axiomsays ihai if PAY(1)
is piefeiied io NOTPAY(1), ihen

PAY(4) is piefeiied io NOT PAY(4). Because L0 is piefeiied io LX, siochasiic dom-
inance, which is implied by ihe IA, says ihai PAY(1)
is piefeiied io PAY(1). Teie-

foie, if PAY(1) is piefeiied io NOT PAY(1), ihen so is PAY(1)
, and ihen PAY(4)

should be piefeiied io NOT PAY(4).
c. Now show ihai ihe choices aie inconsisieni wiih expecied uiiliiy maximizaiion by siaiing whai ihe
decisions mean foi ihe uiiliiy funciion, and deiiving a coniiadiciion.
SoiU1io: Te decisions imply
U(LX) > (I/6)U(D) + (3/6)U(L0) (S4)
(2/3)U(D) + (I/3)U(L0) > (I/2)U(D) + (I/2)U(LX). (S3)
Add (S4) and (S3) and ieaiiange:
U(LX) + (2/3)U(D) + (I/3)U(L0) > (I/6)U(D) + (3/6)U(L0)
+(I/2)U(D) + (I/2)U(LX)
(I/2)U(LX) > (I/2)U(L0).
Bui ihis coniiadicis ihe assumpiion ihai you piefei moie money io less when you
live, i.e., ihai U(LX) < U(L0).
d. Whai is ihe iniuiiion: Use ihe exiieme case, wheie n = 6, as a way io illusiiaie ihe iniuiiion.
SoiU1io: Inboihcases, you inciease ihe chance of suiviving by ihe same amouni
(1/6). Bui ihe gieaiei is n, ihe less you lose in expecied value by paying money,
because ihe moie likely you aie io be dead, when money has no value. If n = 6,
ihen you would pay any amouni io iemove a bullei, since if you doni, youi money
is guaianieed io be woiihless io you anyway.
Exercise 2.10. Ii is said of piefeiences ovei loiieiies ihai saiisfy expecied uiiliiy maximizaiion ihai
ihey aie lineai in piobabiliiies. Tai is, if U : L R is a uiiliiy funciion ovei loiieiies ihai has an
expecied uiiliiy iepieseniaiion, ihen U is a lineai funciion of ihe piobabiliiies of ihe ouicomes. Foi
concieieness, assume ihai ihe sei of ouicomes Z has ihiee ouicomes, z
I
, z
2
and z
3
. Each loiieiy can be
specied by ihiee numbeis: ihe piobabiliiies p
I
, p
2
and p
3
of ihe ihiee ouicomes.
a. Wiiie down ihe maihemaiical deniiion of ihe sei of loiieiies, as a subsei of R
3
. Given an example
of an expecied uiiliiy iepieseniaiion, and use ii io explain ihai ihe uiiliiy funciion ovei loiieiies is lineai
in piobabiliiies.
SoiU1io: Te pioblem is easy (which confused some people). An example of a
uiiliiy funciion on Z is:
u(z
I
) = I u(z
2
) = 3 u(z
3
) = 4.
Foi a loiieiy p
I
, p
2
, p
3
, ihe expecied uiiliiy is
p
I
u(z
I
) + p
2
u(z
2
) + p
3
u(z
3
) = p
I
+ 3p
2
+ 4p
3
,
which is cleaily a lineai funciion of p
I
, p
2
and p
3
.
b. Diaw ihe sei of loiieiies in R
3
ihe besi ihai youi 3D-diawing skills allow. Tis sei should be a
2-dimensional iiiangle, even ihough ii is siiiing in R
3
. Ii is called a simplex.
We can iediaw ihe 2-dimensional iiiangle of loiieiies ai on ihe page:
p
3
= I
p
I
= I p
2
= I
Foi example, ai ihe p
2
= I veiiex, ihe piobabiliiy of z
2
is 1 and ihe piobabiliiy of ihe oihei ouicomes
is zeio. Along ihe side opposiie ihis veiiex, ihe piobabiliiy of z
2
is zeio. Foi all poinis in a given line
paiallel io ihis size, ihe piobabiliiy of z
2
is ihe same.
Specify iwo loiieiies P and Q, and ploi ihem on ihe simplex. Indicaie ihe posiiion of ihe loiieiy
(I/3)P + (2/3)Q, as dened in class.
Foi ihe uiiliiy iepieseniaiion you gave in Pioblem2.10, diawiwo indieience cuives on ihe simplex.
SoiU1io:
Augusi 2006
Chapter 3
States of nature and subjective expected utility
Exercise 3.1. Maximin piefeiences aie appealing in ihe siaies-of-ihe-woild fiamewoik because be-
liefs aboui ihe ielaiive likelihood of evenis is noi impoiiani. A decision model ihai does involve ihe
likelihood of evenis bui does noi involve aibiiiaiy subjeciive beliefs is ihe piinciple of insucieni
ieason. Accoiding io ihis model, in siiuaiions in which ihe piobabiliiy of evenis cannoi be objeciively
deieimined, ihe decision makei assigns each siaie equal piobabiliiy, and ihen acis as an expecied uiil-
iiy maximizei. Foi example, if iheie aie ihiee siaies, sunny, cloudy and iainy, ihen each siaie has
piobabiliiy 1/3. Show ihai ihe piinciple of insucieni ieason can lead io dieieni decisions foi ihe exaci
same decision pioblem depending on how ihe modelei oi decision makei chooses io specify ihe sei of
siaies. Tis iequiies a simple example and a cleai explanaiion.
SoiU1io: I amgoing io pick a fiiend up ai ihe aiipoii and will eiihei leave nowoi
in 1/2 houi. Te ielevani unceiiainiy is wheihei ihe plan aiiives on iime oi laie. If I
lei ihe sei of siaies be {on iime, laie and apply ihe piinciple of insucieni ieason,
ihe piobabiliiy ihai ihe plane is laie is 1/2. Bui if I lei ihe sei of siaies be
{on iime, laie and iains, laie and sunny
and apply ihe piincipal of insucieni ieason, ihen ihe piobabiliiy of ihe eveni ihai
ihe plan is laie is 2/3. Tis can change my decision on wheihei io leave now oi laiei.
Exercise 3.2. Heie aie some decision iheoiies foi ihe Savage seiup (siaies of ihe woild wiihoui ob-
jeciive unceiiainiy) ihai diei fiom Subjeciive Expecied Uiiliiy iheoiy:
Maximin Foi each aciion, iheie is a woisi-case (woisi ovei all possible siaies). Choose ihe aciion
whose woisi-case is ihe besi.
Maximax Foi each aciion, iheie is a besi-case (ovei all possible siaies). Choose ihe aciion whose
besi-case is ihe besi.
Minimax regret Foi each aciion you choose, and each siaie ihai occuis, iheie mighi be some oihei
aciion you wish you had chosen. Te dieience beiween ihe uiiliiy you would have goiien in ihe siaie
if you had chosen ihe besi aciion, and ihe uiiliiy you aciually goi given ihe aciion you chose, is called
ihe regret foi ihai siaie and aciion. Now, foi each aciion, iheie is a woise-case in ieims of iegiei, i.e., a
maximum iegiei ovei all possible siaies. Choose ihe aciion whose maximum iegiei is ihe lowesi.
Insucient reason If you doni knowihe objeciive piobabiliiies of ihe siaies, ihen you should simply
place ihe same piobabiliiy on each siaie. Ten choose ihe aciion ihai maximizes expecied uiiliiy given
ihis piobabiliiy disiiibuiion.
a. Considei ihe following payo maiiix, wheie ihe numbeis aie uiiliiy payos:
Siaies
s
I
s
2
s
3
a
I
0 I0 2
Acis a
2
3 4 0
a
3
2 0 9
Whai decision (choice of an aciion) does each decision iule lisied above lead io: Explain in each case.
Solutions for Chapter 3 (States of nature and subjective expectedutility) 2
SoiU1io:
Maximin Undei ihe maximin ciiieiia, you aie indieieni beiween ihe ihiee
aciions because foi each one ihe minimum payo is 0.
Maximax Besi possible ouicome is 10 foi a
I
, 4 foi a
2
, and 9 foi a
3
. Choose a
I
.
Minimax regret Heie is ihe iegiei foi each aciion and siaie:
Aciion Regiei
Siaie 1 Siaie 2 Siaie 3 Maximum
a
I
3 0 7 7
a
2
0 6 9 9
a
3
1 10 0 10
Teiefoie, aciion a
I
minimizes ihe maximum iegiei.
Insucient reason All siaies aie assigned piobabiliiy 1/3. Expecied payos aie
4 foi a
I
, 7/3 foi a
2
, and II/3 foi a
3
. Teiefoie, choose a
I
.
b. Replace ihe eniiies in ihe payo maiiix by aibiiiaiy piizes. Suppose you only know ihe peisons
oidinal piefeiences ovei (ielaiive ianking of) piizes. Foi which of ihe decision iules given above is ihis
enough infoimaiion io deduce ihe peisons choice: Explain.
SoiU1io: Oidinal piefeiences iank ouicomes, wiihoui any measuie of ihe dif-
feience beiween ihem.
Maximin Tis iule asks you isi io pick ihe woisi possible ouicome foi each
aciion, and ihen io pick ihe besi of ihese ouicomes. You can do ihis knowing only
oidinal piefeiences.
Maximax Like maximin.
Minimax regret Te maximum iegiei foi one aciion mighi depend on ouicome
dieieni fiom ihe ouicomes deieimining ihe maximum iegiei foi anoihei aciion,
and yei you musi compaie ihese quaniiiies. Oidinal piefeiences aie noi enough.
Insucient reason Tis iells you ihe piobabiliiies io use, and ihen io maximize
expecied uiiliiy. You need io know whai uiiliiy funciion io maximize, iaihei ihan
simply oidinal piefeiences.
c. Explain why one mighi say ihai maximin is a pessimisiic decision iule, and ihai maximax is an
opiimisiic decision iule.
SoiU1io: Te maximin ciiieiion impliciily expecis ihai ihe woise possible oui-
come occuis foi each aciion. Te maximax ciiieiion impliciily expecis ihai ihe besi
possible ouicome occuis foi each aciion.
d. Explain why ihe insucieni ieason decision iule is sensiiive io ihe specicaiion of ihe siaies (e.g., io
wheihei you considei iain io be a singe siaie of ihe woild, oi disiinguish beiween iain in ihe moining
Solutions for Chapter 3 (States of nature and subjective expectedutility) 3
only and iain all day).
SoiU1io: If you siaii, e.g., wiih 3 siaies (A, B and C), ihe piobabiliiy of each is
1/3. If you ihen decide ihai siaie A should be divided inio siaies Ai and Aii, ihe
piobabiliiy of each siaies becomes 1/4, and ihe piobabiliiy of ihe old siaie A (now
{Ai,Aii) becomes 1/2.
e. Pick one of ihe decision iules, and compaie ii io SEU, including youi own subjeciive view on which
is beiiei.
SoiU1io: Many possible answeis.
Augusi 2006
Chapter 4
Choosing when there is newinformation
Exercise 4.1. Read Puzzle 2, fiom ihe Winiei 1990 issue of ihe Journal of Economic Perspectives.
Boih ihe quesiion and ihe soluiion aie aiiached. You should deiive and explain ihe soluiion cleaily and
expliciily.
a. Siaii by diawing a iiee iepieseniaiion of ihe unceiiainiy, wiih ihe isi level iesolving wheihei oi
noi ihe paiieni iakes zomepiiac, and ihe second level iesolving wheihei ihe paiieni dies fiom zomepiiac,
dies fiom oihei causes, oi does noi die ai all. Use symbols io label ihe piobabiliiies of all ihe bianches.
SoiU1io:
Figure S10
Take ZP
p
I
Die
from
ZP
q
I
Die
other
causes
q
2
Live
q
3
Not take ZP
p
2
Die
from
ZP
r
I
Die
other
causes
r
2
Live
r
3
b. Inieims of ihese symbols, give ihe foimula foi ihe piobabiliiy ihai ihe woman died fiomzomepiiac,
condiiional on hei having died. (Tis is ihe piobabiliiy ihai ihe puzzle asks you io calculaie.)
SoiU1io: I am using ihe faci ihai r
I
is zeio io omii an p
2
r
I
ieim ihai should
appeai on ihe iop and boiiom:
P[Die fiom ZP | Died fiom ZP oi oihei causes] =
p
I
q
I
p
I
q
I
+ p
I
q
2
+ p
2
r
2
.
c. Siaie whai is known foi suie aboui ihe piobabiliiies in ihe iiee, and why.
SoiU1io: Fiom ihe faci ihai 60% of paiienis iake zomepiiac afei ihe suigeiy,
we conclude ihai p
I
= .6 and p
2
= .4.
Solutions for Chapter 4 (Choosing when there is newinformation) 2
We aie also iold ihai ihe piobabiliiy of dying fiom zomepiiac condiiional on
iaking zomepiiac and dying is 0.93, which gives ihe equaiion:
q
I
q
I
+ q
2
= 0.93.
Tus, q
2
= q
I
/I9.
d. Siaie whai is appioximaiely known aboui ihe piobabiliiy ihai a paiieni dies condiiional on noi
iaking zomepiiac.
SoiU1io: If ihe piobabiliiy of dying fiom oihei causes is noi aecied by iak-
ing zomepiiac (which means, in paiiiculai, ihai deaih fiom oihei causes always
happens befoie deaih fiom zomepiiac, so ihai if one weie io poieniially die fiom
boih zomepiiac and oihei causes, ihe deaih is aiiiibuied io oihei causes), ihen
r
2
= q
2
. If iaking zomepiiac ieduces ihe piobabiliiy of deaih aiiiibuied io oihei
causes because zomepiiac may kill ihe paiieni befoie he oi she has a chance io die
fiom someihing else, ihen q
2
is siill ai leasi (I q
I
)r
2
. If q
I
is small, ihen q
2
is a
good appioximaiion foi r
2
. We aie noi iold ihai q
I
is small, bui ihai is likely since
mosi diugs in use foi ihe ielief of iooih pain do noi kill a ihiid of ihe paiienis.
e. Using ihis appioximaiion and ihe oihei infoimaiion, you can now use ihe foimula fiom (b) io nd
ihe soluiion io ihe puzzle.
SoiU1io: We have r
2
= q
2
= q
I
/I9, and hence ihe piobabiliiy ihai she died fiom
zomepiiac is
0.6q
I
0.6q
I
+ 0.6q
I
/I9 + 0.4q
I
/I9
= 0.9I9.
Augusi 2006
Chapter 5
Risk Preferences
Exercise 5.1. A iisk-aveise decision makei has iniiial wealih of $10,000 and needs io leave $3,000
in ihe hoiel safe. Noi being ihe nicesi hoiel, iheie is siill a 1/4 chance of ihef. Te hoiel will only insuie
againsi ihef if ihe decision makei buys insuiance. Te hoiel will sell ihe decision makei insuiance ai
ihe iaie of $.23 pei dollai of coveiage.
a. On a giaph showing wealih in each siaie, maik ihe aci (siaie-dependeni wealih) ihe DM faces if he
buys no insuiance and maik ihe aci he faces if he buys full insuiance ($3,000 of coveiage).
SoiU1io:
Figure S11
0 23 30 73 I00 I23 I30 I73 200 223 230 273
0
23
30
73
I00
Wealth
w/o theft
Wealth with theft (In 100 of dollars)
43
(risk-free acts)
No insurance
30, I00
Full coverage
87.3, 87.3
b. Diawall ihe acis ihe DM can choose fiom, by vaiying ihe amouni of coveiage (including negaiive
coveiage and excess coveiage, bui wiihoui leiiing wealih in eiihei siaie be negaiive).
SoiU1io:
Solutions for Chapter 5 (Risk Preferences) 2
Figure S12
0 23 30 73 I00 I23 I30 I73 200 223 230 273
0
23
30
73
I00
Wealth
w/o theft
Wealth with theft (In 100 of dollars)
43
(risk-free acts)
c. How much coveiage should ihe DM buy: Give ihe mosi diieci explanaiion you can.
SoiU1io: Full coveiage. All ihe poinis on ihe line in ihe answei foi ihe pievi-
ous quesiion have ihe same expecied value. (I.e, because ihe insuiance is aciuaii-
ally faiiihe cosi pei dollai of coveiages is equal io ihe piobabiliiy of ihefihe
expecied value of ihe nei insuiance iiansaciion is 0, howevei many uniis aie pui-
chased.) Full coveiage has no iisk. Hence, a iisk-aveise decision makei piefeis
full coveiage. (Te aigumeni is ihe same as ihai a iisk-aveise decision makei who
iniiially faces no iisk should noi iake a siake in a faii gamble. We could diaw an
indieience iangeni io ihe budgei line ai ihe 43
degiee line jusi as in class.)

Exercise 5.2. Suppose ihai a peison maximizes his expecied uiiliiy, wiih ihe uiiliiy funciion given
by u(z) = z
I/2
. Suppose ihai ihe peison engages in a iisky veniuie which leaves him wiih eiihei $81 oi
$23, wiih equal piobabiliiy. Whai is ihe ceiiainiy equivaleni of ihis business veniuie: Whai is ihe iisk
piemium:
SoiU1io:
Expecied uiiliiy: (I/2)u(8I) + (I/2)u(23) = (I/2)9 + (I/2)3 = 7
Ceiiainiy equivaleni: u
I
(7) = 49.
Expecied value: (I/2)8I + (I/2)23 = 33.
Risk piemium: 33 49 = 4.
Exercise 5.3. Suppose ihai Mao is an expecied uiiliiy maximizei, wiih ihe VNM uiiliiy funciion
u(x) = log(x), foi x > 0 (use naiuial log).
a. Whai is Maos ceiiainiy equivaleni of ihe following loiieiy:
Piobabiliiy Money
.4 30
.3 100
.1 300
SoiU1io: Te expecied uiiliiy of ihe loiieiy is
.4 log(30) + .3 log(I00) + .I log(300) 4.28.
Teiefoie, ihe ceiiainiy equivaleni is appioximaiely
u
I
(4.28) = e
4.28
72.6.
b. Whai is ihe iisk piemium Mao is willing io pay io insuie againsi ihis unceiiain piospeci:
SoiU1io: Te expecied value of ihe loiieiy is
.4(30) + .3(I00) + .I(300) = II2.
Teiefoie, ihe iisk piemium is II2 72.6 = 39.4.
c. Suppose Mao has $1,200,000 in wealih, and decides io become a backsliding oil piospecioi. He nds
a iiaci of land foi sale foi $1,000,000 dollais, which will pioduce no ieiuin ai all if no oil is found, oi will
yield $10,000,000 of income (nei of opeiaiing expenses bui noi of ihe cosi of ihe land) if oil is found.
Lei p be ihe piobabiliiy ihai oil is found. Specify ihe iwo loiieiies ihai iesuli fiom ihe aciions, buy
ihai land and noi buy ihe land. Whai piobabiliiy p of nding oil would make Mao exacily indieieni
beiween buying ihe land and noi buying ihe land:
SoiU1io: I will measuie ihe ouicomes in ieims of Maos nal wealih:
Buy ihe land
Ouicome Piob
$10,200,000 p
$200,000 I p
Noi buy ihe land
Ouicome Piob
$1,200,000 1
We need io nd p ihai such ihai ihe expecied uiiliiy foi ihe iwo loiieiies speci-
ed above is ihe same. I.e., we nd p ihai solves ihe equaiion:
pu(I0, 200, 000) + (I p)u(200, 000) = u(I, 200, 000)
I.e.,
p = (u(I, 200, 000) u(200, 000))/(u(I0, 200, 000) u(200, 000)) .46
Exercise 5.4. A peison has VNM uiiliiy funciion u(z) = log
I0
z. She has iniiial wealih of $10,000
and has become a nalisi in a loiieiy such ihai hei iickei will pay o $990,000 wiih piobabiliiy 1/2, and
$0 wiih piobabiliiy 1/2. Whai is ihe minimum amouni of money she would be willing io ieceive in
exchange foi ihe iickei: Show youi calculaiions.
SoiU1io: Wiih ihe iickei, she faces ihe aci ihai has ouicomes $1,000,000 and
$10,000 wiih equal piobabiliiy. Hei expecied uiiliiy is
(I/2) log
I0
(I, 000, 000) + (I/2) log
I0
(I0, 000) = 3.
Hei ceiiainiy equivaleni foi ihis loiieiy is iheiefoie
u
I
(3) = I0
3
= I00, 000.
She geis hei ceiiainiy equivaleni if she ieceives $90,000 foi ihe loiieiy (since she
has iniiial wealih of $10,000). Tis is ihe minimum amouni she would accepi foi
ihe loiieiy iickei.
Exercise 5.5. A iisk-aveise VNM decision makei has decreasing absoluie iisk aveision. Hei cei-
iainiy equivaleni foi a loiieiy ihai pays $0 and $800 wiih piobabiliiies 1/3 and 2/3, iespeciively, is $300.
a. Which does she piefei, io gei $400 and $1200 wiih piobabiliiies 1/3 and 2/3, iespeciively, oi io gei
$900 foi suie: (Explain.)
b. How does she iank ihe loiieiies in Figuie E3.1: (Explain.)
Figure E5.3
P
$700
I
2
$1000
I
2
Q
$800
I
2
$400
I
6
$1200
I
3
Exercise 5.6. Kieps, A Course , p. 131, Pioblem 13.
SoiU1io: Te iiick heie is io iealize ihai ihe infoimaiion ihai ihe DM has con-
siani absoluie iisk aveision iells you ihai hei uiiliiy funciion is u(z) = e
z
. Ten,
knowing ihe ceiiainiy equivaleni foi one of ihe loiieiies leis you solve (numeiically)
foi . Once you know ihe uiiliiy funciion, you can compaie any loiieiies.
Te ceiiainly equivaleni infoimaiion iells you ihai:
u(470) = .3u(0) + .3u(I000)
e
470
= .3 .3e
I000
Solving ihis numeiically yields = .00024. Ten, ihe uiiliiy foi ihe ihiee loiieiy
is:
e
.00024(200)
= 0.933I3
(.3e
.00024(0)
+ .3e
.00024(200)
+ .Ie
.00024(430)
+ .Ie
.00024(I000)
) = 0.93437
(.23e
.00024(0)
+ .23e
.00024(I00)
+ .23e
.00024(200)
+ .23e
.00024(320)
) = 0.93302
Teiefoie, ihe ihiid loiieiy is ihe besi.
Exercise 5.7. Considei a peison who has ihe following piecewise-lineai uiiliiy funciion:
u(z) =
2z z < $I, 000

I000 + z z $I, 000.
Giaph ihis uiiliiy funciion. Does ihe peison have incieasing oi decieasing absoluie iisk aveision ovei
ihe domain of hei uiiliiy funciion (e.g., 0 io $2,000): Explain. Do noi iiy io apply a mechanical ciiieiion,
such as ihe measuies of iisk aveision ihai use dieieniiaiion. Insiead, diiecily apply ihe deniiion of
incieasing and decieasing absoluie iisk aveision.
SoiU1io: Heie is ihe giaph:
0 400 800 I200 I600
0
400
800
I200
I600
2000
2400
2800
u(z)
Tis uiiliiy funciion exhibiis neiihei incieasing noi decieasing absoluie iisk avei-
sion ovei ihe domain of ihe uiiliiy funciion.
We can illusiiaie ihis by a loiieiy z such ihai ihe iisk piemium foi w + z isi
incieases in w and ihen decieases in w. Lei z yield 400 and 400 wiih equal piob-
abiliiy. If w = 300 ihen ihe values of w + z all fall in ihe isi ai segmeni; ihe iisk
piemium is ihus zeio. If w = I300 ihen ihe values of w + z all fall in ihe second
ai segmeni; again ihe iisk piemium is ihus zeio. If w = I000 ihe values fall above
and below ihe kink; ihe iisk piemium is ihus posiiive (e.g., see ihe dashed line in
ihe giaph).
Te ieason we cannoi apply ihe Aiiow-Piaii measuie of absoluie iisk aveision
is ihai ihis funciion is noi dieieniiable.
Exercise 5.8. Considei a peison who has decreasing absolute iisk aveision and constant relative iisk
aveision. Lei x be ihe iisky nei pioi of a paiiiculai business veniuie, and lei w be ihe peisons iniiial
wealih, so ihai ihe peisons ioial wealih given ihe veniuie is w + x. Suppose ihai if w = 200, ihen ihe
peisons iisk piemium foi ihe veniuie x is $10.
a. Can you say wheihei ihe iisk piemium if ihe iniiial wealih weie $300 would be gieaiei ihan, less
ihan oi equal io $10:
SoiU1io: Wiih decieasing absoluie iisk aveision, ihe iisk piemium musi fall as
iniiial wealih incieases. Hence, ihe iisk piemium when w = 300 is less ihan $10.
b. Whai is ihe iisk piemium foi a iisky veniuie 3 z if ihe iniiial wealih is 600: (Explain)
SoiU1io: If boih wealih iiiples and ihe siake in ihe veniuie iiiples and iheie is
consiani ielaiive iisk aveision, ihe iisk piemium should iiiple as well. I.e., ii should
be $30.
Exercise 5.9. Considei ihe example in Figuie 3.6, which illusiiaies ihai vaiiance is noi a sucieni
measuie of iisk. In ihe example, y is piefeiied io x. Diaw a similai example wiih ihe same acis bui a
dieieni concave uiiliiy funciion such ihai x is piefeiied io y.
SoiU1io: E.g., diaw a piecewise-lineai uiiliiy funciion ihai has a single kink ai
x
2
.
Exercise 5.10. You aie iiying io decide how io invesi $3,000. Only money ouicomes maiiei and
youi piefeiences ovei money aie siaie independeni. Heie aie foui invesimeni oppoiiuniiies, iogeihei
wiih ihe possible ouicomes:
Investment Possible outcomes
A Buy $3,000 of bonds fiom ihe Hungaiian
Siaie Bank
lose $3000 oi win $1000
B Bei $2000 ihai a piesideniial candidaie will
pledge io iaise iaxes
lose $2000 oi win $30000
C Buy $3000 of euios lose $300 oi win $800
D Send youi delinqueni son io college lose $3000
You know ihai each ouicome can occui wiih posiiive piobabiliiy and you know ihai ihe expecied payos
foi invesimenis A, B and C aie ihe same (bui you doni know whai ihis mean is).
Siaie wheihei each of ihe following second-oidei siochasiic dominance ielaiions is iiue, false oi
unceiiain (given ihe infoimaiion you have) and give a biief explanaiion:
1. A s.o.s.d. B;
2. C s.o.s.d. A;
3. A s.o.s.d. D.
SoiU1io:
1. False. We know ihai when compaiing iisky piospecis wiih iwo ouicomes each
and wiih ihe same mean, one is iiskiei ihan ihe oihei (and ihus second-oidei
siochasiically dominaies ihe oihei) if and only if ihe ouicomes of ihe foimei aie
nesied wiihin ihe ouicomes of ihe laiiei. (Unceiiain is ihe wiong answei. In
ihis case, no piospeci second-oidei siochasiically dominaies ihe oihei. Whai is
unceiiain is which of ihese a iisk-aveise decision makei wiih incieasing uiiliiy
would piefei.)
2. Tiue. Foi ihe ieason given above.
3. Tiue. Aciually, A also isi-oidei siochasiically dominaies (oi jusi plain domi-
naies) D. Whaievei happens, you aie beiiei o undei A ihan undei D (unless
youi son is going io live ai home insiead). Te pioblem is woided io imply ihai
you doni expeci anyihing good io come oui of youi sons aiiendance ai college.
Exercise 5.11. Whai is wiong wiih ihis ieasoning: Suppose x and y have ihe same mean and y is
less iisky ihan x, so ihai we can wiiie
x
d
= y +
foi some such ihai E[ | y] = 0. Ten we can also wiiie
y
d
= x .
Since ihe expecied value of is 0, so is ihe expecied value of . Teiefoie, y is also iiskei ihan x.
SoiU1io: Fiisi, one cannoi iieai
d
= like ihe algebiaic equaliiy =and move ihings
fiomone side of ihe equaliiy io ihe oihei. Second, even if we aciually have x = y+ ,
so ihai y = x and E[ ] = 0, we siill do noi know ihai E[ | x] = 0.
Exercise 5.12. Aconsumei musi choose beiween (A) a suie paymeni of $400 and (B) a gamble wiih
piizes $0, $100, $600 and $1000 wiih piobabiliiies 0.23, 0.1, 0.4 and 0.23, iespeciively. All you know is
ihai (i) ihe consumei saiises ihe VNM axioms foi ihis kind of loiieiy, (ii) she is iisk aveise, (iii) she
piefeis moie money ovei less, and (iv) hei iisk piemium foi a gamble (C) wiih piizes $0 and $1,000,
equally likely, is $100. Show ihai ihe consumei iheiefoie musi piefei B ovei A. (If youi answei is geiiing
complicaied, you aie on ihe wiong iiack. Te idea of incieasing iisk is useful.)
SoiU1io: Lei C be ihe loiieiy wiih piizes $0 and $1000, equally likely. B and
C have ihe same mean of $300. Because of ihis and because ihe ouicomes of B
aie nesied in ihe ouicomes of C, B is less iisky ihan C. Since uiiliiy of money is
incieasing, ihis means ihai ihe iisk piemium of B is lowei ihan ihe iisk piemium
of C and hence is less ihan $100. Te ceiiainiy equivaleni of B is ihus highei ihan
$400, which means ihai B is piefeiied io A.
Exercise 5.13. Show ihai ihe iandom piospeci x in Figuie E3.2 is less iisky ihan y by showing ihai
y
d
= x + wiih E[ | x] = 0:
Figure E5.4
x
I0
2
3
20
I
3
y
3
I
3
I3
3
9
30
I
9
SoiU1io: Te iandom piospeci x + in Figuie S13 has ihe same disiiibuiion as
y. Ii is easily veiied also ihai E[ | x] = 0.
Figure S13
x

x +
I0
2
3
3
I
2
5
+3
I
2
15
20
I
3
3
2
3
15
+I0
I
3
30
Exercise 5.14. Lei P be a loiieiy ihai pays $20 wiih piobabiliiy 1/3 and $40 wiih piobabiliiy 2/3. Lei
Q be a loiieiy ihai pays $10 wiih piobabiliiy 1/6, $30 wiih piobabiliiy 11/18, and $60 wiih piobabiliiy
2/9. Show ihai P is less iisky ihan Q by showing ihai iheie aie iandom vaiiables x, y and such ihai (i)
P is ihe disiiibuiion of x, (ii) Q is ihe disiiibuiion of y, (iii) E[ | x] = 0, and (iv) y and x + have ihe
same disiiibuiion.
SoiU1io: We have io consiiuci a iandom vaiiable such ihai x + and y have
ihe same disiiibuiion and such ihai E[ | x] = 0. Te suppoiis of x + and y have
io be ihe same: {I0, 30, 60. Hence, if x = 20, ihen can only be equal io I0, 20
and 40, wheieas if x = 40, ihen can only be equal io 30, I0 and 20. We can
iepieseni x + by ihe iiee in Figuie S14.
Figure S14
x
x +
20
I
3
-10
I0
r
I
10
30
r
2
40
60
r
3
40
2
3
-30
I0
s
I
-10
30
s
2
20
60
s
3
Oui iask is io nd ihe piobabiliiies {r
I
, r
2
, r
3
, s
I
, s
2
, s
3
. Leis wiiie down all ihe
iesiiiciions ihese numbeis have io saiisfy.
Fiisi, ihe condiiional piobabiliiies have io be posiiive and ihey have io sum io
1:
r
I
, r
2
, r
3
, s
I
, s
2
, s
3
0
r
I
+ r
2
+ r
3
= I
s
I
+ s
2
+ s
3
= I.
Second, ihe condiiion E[ | x] = 0 denes iwo equaiions:
E[ | x = 20] = 0 r
I
(I0) + r
2
(I0) + r
3
(40) = 0
E[ | x = 40] = 0 s
I
(30) + s
2
(I0) + s
3
(20) = 0.
Tiid, ihe condiiion y
d
= x+ denes one equaiion foi each of ihe ihiee possible
ouicomes (e.g., Piob [ y = I0] = Piob [ x + = I0]):
I
3
r
I
+
2
3
s
I
=
I
6
I
3
r
2
+
2
3
s
2
=
II
I8
I
3
r
3
+
2
3
s
3
=
2
9
Guessing ihai r
3
= s
I
= 0, ihe consiiainis ihai ihe piobabiliiies sum io 1 and
ihai E[ | x] = 0 imply ihai
r
I
= I/2, r
2
= I/2, s
2
= 2/3, s
3
= I/3.
Te iesuliing iwo-siage loiieiy is ihe following:
x
x +
20
I
3
-10
I0
I
2
10
30
I
2
40
2
3
-10
30
2
3
20
60
I
3
Te y
d
= x + equaiions aie seen io be saiised, so ihis is a soluiion.
Exercise 5.15. Lei w be independeni of boih x and y. x and y aie iwo iandom piospecis ihai a
decision makei wiih uiiliiy u is choosing beiween. w is ihe decision makeis oihei wealih. Assume ihai
u is incieasing and concave and assume ihai x second-oidei siochasiically dominaies y.
a. Applying ihe law of iieiaied expeciaiions, show ihai
E[u( w + x)] > E[u( w + y)].
SoiU1io: Foi xed w, w+ x second-oidei siochasiically dominaies w+ y. Teie-
foie,
E[u(w + x)] > E[u(w + y)] (S6)
Taking ihe expeciaiion of (S6) wiih iespeci io w, ihe inequaliiy coniinues io hold
(i.e., a i.v. ihai is always gieaiei ihan anoihei i.v. has a highei expecied value ihan
ihe oihei i.v.):
E
w
[E
x
u( w + x)| w = w] > E
w
[E
y
u( w + y)| w = w] (S7)
Applying ihe law of iieiaied expeciaiions:
E[u( w + x)] > E[u( w + y)] (S8)
b. Conclude ihai w + x second-oidei siochasiically dominaies w + y.
SoiU1io: By deniiion, if (S8) holds foi all (siiicily) concave and incieasing u,
w + x second-oidei siochasiically dominaies w + y.
c. Give an example ihai illusiiaies ihai ihis is noi iiue if w is noi independeni of x and y.
SoiU1io: Lei w be ihe ouicome of a iisk. Lei x be 0 always and lei y be faii
insuiance foi ihe iisk, so ihai E[ y] = 0 and w + y equals zeio always. Ten y is
iiskiei ihan x, bui w + y is less iisky ihan w + x.
d. Explain how ihis iesuli mighi help you if you aie managing a poiifolio foi someone whose iisk
piefeiences you do noi fully know (e.g., foi youiself!) oi if you aie iiying io piedici ihe behavioi of
agenis whose piefeiences you do noi fully know.
SoiU1io: If x s.o.s.d. y, ihen I should choose an invesimeni leading io x iaihei
ihan y, even if my clieni faces oihei unceiiainiy ihe deiails of which I do noi know,
excepi ihai ii is independeni of ihe payos fiom my poiifolio invesimenis. I would
also piedici ihai a iisk-aveise decision makei wiih an incieasing uiiliiy funciion
would choose x ovei y, even if ihe decision makei faces uncoiielaied iisks aboui
which I am unawaie.
Augusi 2006
Chapter 6
Market Decisions in the Presence of Risk
Exercise 6.1. You have jusi moved io ihe Uniied Siaies fiomMexico. Youi ieiiiemeni savings consisi
of peso-denominaied bonds issued by ihe Mexican goveinmeni. You will ihen spend youi ieiiiemeni
money in ihe Uniied Siaies. Suppose ihai iheie is no chance of defauli by ihe Mexican goveinmeni, and
youi bonds will be woiih 1 million pesos ai maiuiiiy. Howevei, ihe value of youi nesi egg in US$ is
unceiiain because of exchange-iaie unceiiainiy. Suppose also ihai ihe fuiuie value of ihe peso is eiihei 3
pesos/dollai (siaie 1) oi 2 pesos/dollai (siaie 2), and you believe ihese siaies will occui wiih piobabiliiies
I
= I/3 and
2
= 2/3, iespeciively.
You can acquiie a foiwaid coniiaci ihai iequiies you io exchange, foi each unii of ihe coniiaci you
acquiie, 1000 pesos foi US$330. Te cuiieni piice of ihis coniiaci is zeio.
In ihe quesiions below, lei an allocaiion oi aci be ihe siaie-dependeni dollai value of youi ieiiiemeni
funds, afei liquidaiing any holdings of ihe foiwaid coniiaci. Assume ihai you aie a VNM expecied
uiiliiy maximizei wiih iisk-aveise, siaie-independeni piefeiences and dieieniiable uiiliiy.
You aie io diaw some ihings on ihe giaph in Figuie E6.1.
a. Maik youi baseline allocaiion on ihe giaph.
b. Deiive ihe budgei consiiaini youi allocaiions musi saiisfy, and ideniify ihe siaie piices.
c. Diaw ihe budgei line (assuming you can boih buy and sell ihe foiwaid coniiaci) and a vecioi fiom
ihe budgei line poiniing in ihe diieciion of ihe siaie piices.
d. Using jusi ihe infoimaiion you have been given, whai can you say aboui ihe posiiion of ihe opiimal
allocaiion in ihe budgei line:
e. Seleci a possible opiimal allocaiion. Diaw a plausible indieience cuive ihiough ihe allocaiion. In-
dicaie ihe slope of ihe indieience cuive wheie ii ciosses ihe 43
line by diawing a vecioi peipendiculai

io ihe indieience cuive ai ihai poini.
Exercise 6.2. Suppose ihai in a maikei foi siaie-coniingeni coniiacis wiih iwo siaies, iheie aie ihiee
asseis, wiih payos and piices as follows:
Payos
Asset Price State 1 State 2
x $200 $100 $300
y $130 $223 $73
z $130 $120 $160
Te pioblem is io choose ihe opiimal poiifolio given a xed ioial invesimeni. Assume ihai ihe siaies
have equal piobabiliiy. Assume isi ihai shoii sales aie noi possible. Whai can you say aboui ihe opiimal
poiifolio: Now assume ihai shoii sales aie possible (ii is possible io buy a negaiive amouni of an assei),
and again desciibe ihe opiimal poiifolio. Noie: Tis is a iiick quesiion.
Solutions for Chapter 6 (Market Decisions in the Presence of Risk) 2
Figure E6.5. Graph for Problem 6.1.
0
I
0
0
2
0
0
3
0
0
4
0
0
3
0
0
6
0
0
7
0
0
8
0
0
9
0
0
I
0
0
0
I
I
0
0
I
2
0
0
0
I
0
0
2
0
0
3
0
0
4
0
0
3
0
0
6
0
0
7
0
0
8
0
0
4
3
M
o
n
e
y
S
t
a
t
e
1
M o n e y S t a t e 2
SoiU1io: Lei A be ihe poiifolio consisiing of 1/2 uniis of x and 1/3 uniis of y.
Te piice is (I/2)200+(I/3)I30 = I30, ihe payo in siaie 1 is (I/2)I00+(I/3)223 =
I23, and ihe payo in siaie 2 is (I/2)300 + (I/3)73 = I73. Leis compaie ihis wiih
ihe piice and ieiuin of assei z:
Yields
Asset Price State 1 State 2
A $130 $123 $173
z $130 $120 $160
You can see ihai poiifolio A dominaies assei z. (A is noi ihe unique poiifolio ihai
dominaies z. You may have consiiucied a dieieni poiifolio.) Hence, by domi-
nance, ihe opiimal poiifolio could nevei have a posiiive amouni of z: if z weie
posiiive, ieducing z and puichasing A insiead would inciease ihe payo in both
states. Tis is an example of an aibiiiage oppoiiuniiy.
Suppose shoii sales aie noi possible: We have jusi shown ihai ihe poiifolio can
coniain no uniis of z. We cannoi say moie aboui how much of asseis x and y will
be puichased, wiihoui knowing ihe piobabiliiies of ihe iwo siaies. E.g., if siaie 2 is
moie likely ihan siaie 1, ihen ihe invesioi mighi opiimally invesi all hei wealih in
assei x.
Suppose shoii sales aie possible: Ii is possible io exploii ihis aibiiiage oppoiiu-
niiy io obiain unlimiied wealih in boih siaies. Jusi sell many uniis of assei z and
puichase ihe same numbei of uniis of poiifolio A. Hence, ihe pioblem has no so-
luiion. One can conclude ihai ihese assei piices cannoi be equilibiium assei piices,
bui you weie noi asked io make ihis infeience.
Exercise 6.3. Considei a poiifolio seleciion pioblem in which a iisk-aveise invesioi has $1 of wealih
io invesi, and iheie aie iwo iisky asseis available whose gioss ieiuins, pei dollai invesied, aie x and y.
Assume ihai x and y aie independeni, and have ihe same mean, alihough ihey may noi be ideniically
disiiibuied. Show ihai ihe invesioi will noi pui all his money in ihe same assei (e.g., noi all in x). Tis
will involve dieieniiaiion, and you have io use ihe faci ihai foi a iandomvaiiable z (ihai is noi consiani)
and a decieasing funciion f , E[ z f ( z)] < E[ z]E[ f ( z )].
SoiU1io: Te ieiuin when invesiing I in x (and hence in y) is (I) x+ y.
Expecied uiiliiy V() as a funciion of is
V() = E[u((I ) x + y)] .
Dieieniiaiing:
V
() = E[( x + y)u
((I ) x + y) .
Evaluaied ai = 0:
V
()|
=0
= E[( x + y)u
( x)] = E[ xu
( x)] + E[ yu
( x)] .
Since x and y aie independeni, E[ yu
( x)] = E[ y]E[u
( x)]. Since u
is decieasing
(fiom iisk aveision), E[ xu
( x)] < E[ x]E[u
( x)]. Teiefoie,
V
()|
=0
> E[ x]E[u
( x)]+E[ y]E[u
( x)] = (E[ x]+E[ y])E[u
( x)] = 0 .
Ten V() is incieasing ai = 0, so = 0 cannoi be opiimal.
Exercise 6.4. We showed ihai if uiiliiy is dieieniiable, ihen a peison is willing io accepi some shaie
of a favoiable gamble. E.g., we concluded ihai if insuiance is noi aciuaiially faii, ihen a peison will noi
buy full insuiance, and if an invesioi divides his poiifolio among a iiskless assei and a iisky assei wiih
highei expecied ieiuin, ihen he will invesi ai leasi some amouni in ihe iisky assei.
a. Suppose ihai one can buy insuiance ihai is aciuaiially faii, excepi foi a xed fee ihai does noi depend
on ihe exieni of coveiage. Will a iisk-aveise peison buy full insuiance if he buys any ai all: Explain.
SoiU1io: Te xed fee mighi keep him fiom buying insuiance, bui if he buys
insuiance ai all, ihe fee should noi aeci how much insuiance is boughi since ii is
jusi a consiani ieim in ihe maximizaiion pioblem. Hence, if he buys an insuiance
ai all, he will buy full insuiance.
b. Suppose ihai iheie is a xed biokeis fee on siock maikei iiansaciions, ihai does noi depend on ihe
size of ihe iiansaciion. Is ii siill iiue ihai an invesioi will pui ai leasi some of his wealih inio a iisky siock
whose expecied ieiuin is highei ihan ihe ieiuin on ihe iiskless assei:
SoiU1io: Noi necessaiily. Te iesuli we showing in class is ihai iheie is some
gain fiom buying some amouni of ihe assei, bui ihai gain can be aibiiiaiily small.
If ihe biokeis fee is high enough, ii can oveiiide ihe gain.
c. Exeicise 6.3 shows ihai, if an invesioi divides his poiifolio among a iiskless asseis and seveial iisky
asseis wiih independeni ieiuins ihai aie highei ihan ihe ieiuin on ihe iiskless assei, ihen if ihe invesioi
holds any of ihe iiskless assei, he also holds some amouni of each of ihe iisky asseis.
We can ioughly say ihai puiiing money inio a bank accouni is a iiskless invesimeni. Teie aie also
zillions of iisky invesimenis oui iheie in ihe woild wiih ioughly independeni ieiuins and wiih expecied
ieiuins ihai aie highei ihan ihe ieiuin on a bank accouni.
Do you have any money in a bank accouni: Do you also hold a liiile bii of each of ihe zillions of
iisky invesimenis meniioned above, as oui iheoiy would piedici: Why noi: (Ai mosi a shoii paiagiaph
is sucieni.)
SoiU1io: Jusi as in ihe pievious quesiion, iheie aie iiansaciions cosis io invesi-
ing in asseis. In addiiion io biokeis fee, one has io go ihiough ihe iiouble of nding
oui whai invesimenis aie available and ihen io moniioi ihe invesimenis. Teiefoie,
you piobably doni invesi in veiy many asseis, unless you happened io have oodles
of money io invesi.
Exercise 6.5. Show ihai if a uiiliiy funciion u is dieieniible and siiicily incieasing and exhibiis
consiani oi decieasing absoluie iisk aveision, ihen u
> 0.
SoiU1io:
R
A
(c) =
u
A
(c) =
u
+
(u
)
2
(u
)
2
If R
A
0, ihen
u

(u
)
2
(u
)
2
> 0
Since u
> 0, ihis implies u
> 0.
Exercise 6.6. Considei a im ihai pioduces a quaniiiy y of a single good ai known cosi c(y). Pioi
when ihe piice is p is py c(y). We compaie iwo cases: (a) when ihe piice is unceiiain, equal io ihe
iandom vaiiable p (ihe unceiiainiy case), and (b) when ihe piice is ceiiain, equal io p = E
_
p
_
foi suie
(ihe ceiiainiy case).
a. Scenaiio: Te im chooses ihe level of ouipui befoie obseiving ihe piice of ouipui. Te ownei of
ihe im is iisk neuiial wiih iespeci io piois.
1. Siaie ihe maximizaiion pioblems foi ihe iwo cases and deieimine wheihei oi noi ihe iwo pioblems
aie equivaleni.
2. How do ihe soluiions and values of ihe iwo maximizaiion pioblems compaie:
SoiU1io: Given iisk neuiialiiy, ihe ownei chooses y in ihe unceiiainiy case io
maximize expecied piois:
E
_
py c(y)
_
= E[ p]y c(y) = py c(y).
Tis is also ihe objeciive funciion in ihe ceiiainiy case. Teiefoie, ihe maximizaiion
pioblems aie equivaleni and have ihe same soluiions and values.
b. Scenaiio: Te im chooses ihe level of ouipui befoie obseiving ihe piice of ouipui. Te ownei of
ihe im is a iisk-aveise expecied uiiliiy maximizei wiih iespeci io piois, foi a siiicily incieasing and
siiicily concave uiiliiy funciion u. Tai is, uiiliiy when ouipui is y and ihe piice is p is u(py c(y)).
1. Lei U(y) be ihe objeciive funciion foi ihe unceiiainiy case and lei V(y) be ihe objeciive funciion foi
ihe unceiiainiy case. Siaie ihe foimulae foi U and V. Foi which case is ihe maximizaiion pioblem
equivaleni io when ihe ownei is iisk neuiial:
2. Assuming only ihai each pioblem has a non-zeio soluiion, compaie ihe values of ihe maximizaiion
pioblems.
3. Piove: If y
I
and y
2
aie soluiions wiih and wiihoui unceiiainiy, iespeciively, ihen y
I
y
2
.
(You should noi use calculus noi add any auxilaiy assumpiions on u. Insiead, you should show
ihai, if y
2
is a soluiion io ihe ceiiainiy pioblem and y
I
> y
2
, ihen ihe pioi given y
2
second-oidei
siochasiically dominaies ihe pioi given y
I
. Foi ihis puipose, you can use ihe faci ihai, if x is a
non-degeneiaie iandom vaiiable and if
I
,
2
,
I
,
2
aie such ihai
I
>
2
and E
_
I
x
I
_

E
_
2
x
2
_
, ihen
2
x
2
second-oidei siochasiically dominaies
I
x
I
.)
4. Assume foi ihe iesi of ihis paii ihai c and u aie dieieniiable. Piovide ihe foimulae foi U
(y) and
V
(y) and simplify ihe isi-oidei condiiion in ihe ceiiainiy case.

3. Can you deieimine wheihei U
(y) < V
(y) oi U
(y) > V
(y) foi all y:

6. Show ihai, if y
2
is an inieiioi soluiion in ihe ceiiainiy case, ihen U
(y
2
) < 0.
7. Conclude ihai, if y
I
and y
2
aie soluiions wiih and wiihoui unceiiainiy, iespeciively, ihen y
I
< y
2
.
SoiU1io:
1.
U(y) = E
_
u( py c(y))
_
V(y) = u( py c(y))
In ihe ceiiainiy case, u( py c(y)) is an incieasing monoionic iiansfoimaiion
of py c(y), and hence an equivaleni objeciive funciion is py c(y), ihe same
as in ihe ceiiainiy case.
2. We show ihai U(y) < V(y) foi all y > 0. Te iesuli ihen follows.
Lei y > 0. py c(y) is iandom and iis expecied value is py c(y). Since
u is siiicily concave, U(y) = E
_
py c(y)
_
< py c(y) = V(y).
3. Lei y
2
be a soluiion wiihoui unceiiainiy. Lei y
I
> y
2
. Te piois in ihe uncei-
iainiy case given y
I
and y
2
aie, iespeciively,
I
= py
I
c(y
I
) and
2
y
2
c(y
2
).
Obseive ihai E[
I
] = py
I
c(y
I
) and E[
2
] = py
2
c(y
2
). Because y
2
is a
soluiion in ihe ceiiainiy case, py
I
c(y
I
) py
2
c(y
2
). Accoiding io ihe hini,

2
second-oidei siochasiically dominaies
I
. Teiefoie, E[u(
I
)] < E[u(
2
)],
i.e., U(y
I
) < U(y
2
). Teiefoie, y
I
is noi a soluiion in ihe ceiiainiy case. Tis
implies ihai, foi any soluiion y
I
in ihe ceiiainiy case, y
I
y
2
.
4.
U
(y) = E
_
( p c
(y))u
( py c(y))
_
V
(y) = ( p c
(y))u
( p c(y)).
In ihe ceiiainiy case, ihe f.o.c. is p c
(y) = 0.
3. We need io compaie E
_
( p c
(y))u
( py c(y))
_
and ( p c
(y))u
( p c(y))
foi an aibiiiaiy y.
Because u
is decieasing and because boih p c
(y) and py c(y) aie

incieasing in p, pc
(y) and u
( pyc(y)) aie negaiively coiielaied. Teiefoie,

E
_
( p c
(y))u
( py c(y))
_
E
_
( p c
(y))
_
E
_
u
( py c(y))
_
(S9)
= ( p c
(y))E
_
u
( py c(y))
_
.
Teie aie seveial ieasons ihai equaiion (S9) is noi enough io compaie U
(y)
and V
(y). Fiisi, ( p c
(y)) can be posiiive oi negaiive, and so even if, e.g.,

E
_
u
( py c(y))
_
< u
( py c(y)), we cannoi conclude unambiguously ihai

U(y) < V(y). Second, suppose we iesiiici aiieniion io y such ihai p c
(y) >
0. If u
weie concave so ihai E

_
u
( py c(y))
_
< u
( py c(y)), ihen we could

unambiguously conclude ihai U
(y) < V
(y). Howevei, u
cannoi be a concave
funciion because ii is decieasing bui bounded below by 0. If we had io make
an assumpiion aboui ihe cuivaiuie of u
, ii would be ihai ii is siiicily convex

(u
> 0). Bui ihis leads io ihe opposiie conclusion: ihai E

_
u
( py c(y))
_
>
u
( py c(y)). Tis inequaliiy conicis wiih ihe one in equaiion (S9) and hence
we cannoi deieimine wheihei U
(y) oi V
(y) is laigei.
6. If y
2
is an inieiioi soluiion in ihe ceiiainiy case, ihen p c
(y) = 0 (fiom
ihe isi-oidei condiiion). Teiefoie, ( p c
(y
2
))E
_
u
( py
2
c(y
2
))
_
= 0, and
fiom equaiion (S9), U
(y
2
) = E
_
( p c
(y
2
))u
( py
2
c(y
2
))
_
< 0.
7. Lei y
I
and y
2
be soluiions in ihe unceiiainiy case and ihe ceiiainiy case, ie-
speciively. Fiom siep (3), we know ihai y
I
y
2
. Fiom siep (6), we know ihai
y
I
= y
2
. Hence, y
I
< y
2
.
c. Scenaiio: Te im chooses ouipui afer obseiving ihe piice. Te im is iisk neuiial wiih iespeci
io pioi. Viewed fiom befoie obseiving ihe piice, ihe decision pioblem of ihe im is io choose a plan
y : R
+
R
+
which siaies ihe level of ouipui y(p) as a funciion of ihe obseived piice p.
Assuming only ihai each pioblem has a soluiion, show ihai ihe (ex-anie) value of ihe pioblem in
ihe unceiiainiy case is highei ihan ihai of ihe pioblem in ihe ceiiainiy case. Show ihai ihe values aie
ihe same only if, in ihe unceiiainiy case, iheie is a soluiion in which ihe ouipui level does noi depend
on ihe piice.
SoiU1io: In ihe unceiiainiy case, foi each piice p, y(p) solves ihe following
maximizaiion pioblem:
max
y
py c(y).
In ihe ceiiainiy case, ihe maximizaiion pioblem is ihai same as in paii (a).
Lei y
2
be a soluiion in ihe ceiiainiy case. Suppose ihai ihe ownei adopis ihe de-
cisioniule ihai y(p) = y
2
foi all p. Tenihe owneis expecied pioi is E
_
py
2
c(y
2
)
_
=
py
2
c(y
2
), which is jusi ihe value in ihe unceiiainiy case. Teiefoie, ihe value
in ihe unceiiainiy case is ai leasi as high. Unless ihis consiani decision iule is a
soluiion, ihe value in ihe unceiiainiy case is highei ihan in ihe ceiiainiy case.
Exercise 6.7. Suppose ihai a peison can woik ai a iandom houily wage w (always siiicily posi-
iive), wiih mean w (ihe peison mighi woik on a commission basis, oi be an eniiepieneui). Te money
eained is used io buy a single consumpiion good wiih piice 1. Lei ihe uiiliiy fiom woiking x houis and
consuming c uniis be
U(c, x) = u(c) x ,
wheie u is a siiicily incieasing, siiicily concave funciion. Te peison maximizes expecied uiiliiy.
a. Denoie by V(x) ihe expecied uiiliiy as a funciion of ihe numbei of houis woiked. Wiiie down
V(x) in ieims of x, w and u.
SoiU1io: V(x) = E[u(x w)] x.
b. Wiiie down ihe isi-oidei condiiions foi expecied uiiliiy maximizaiion.
SoiU1io: V
(x) = E[ wu
(x w)] I = 0.
c. Veiify ihai ihe second-oidei condiiion foi a siaiionaiy poini io be a unique global maximum is
saiised.
SoiU1io: V
(x) = E[ w
2
u
(x w)] < 0, since u
< 0 and w
2
> 0.
d. Deieimine wheihei ihe peison will woik less oi moie ihe iiskiei ihe wage is, assuming ihai u(c) =
c
I/2
.
SoiU1io: Since u
(c) = (I/2)c
I/2
, ihe isi-oidei condiiion can be wiiiien:
E[ w(I/2)(x w)
I/2
] I = (I/2)x
I/2
E[ w
I/2
] I = 0 .
Rewiiiing:
x = (I/4)(E[ w
I/2
])
2
.
Since f (w) = w
I/2
is concave, E[ w
I/2
] decieases as w becomes iiskiei. Teiefoie,
ihe opiimal x falls as ihe wage becomes iiskiei.
Exercise 6.8. A iisk-aveise expecied-uiiliiy maximizei has iniiial wealih w and uiiliiy funciion u.
She faces a iisk of a nancial loss of L dollais, which occuis wiih piobabiliiy . An insuiance company
oeis io sell a policy ihai cosis P dollais pei dollai of coveiage (pei dollai paid back in ihe eveni of a
loss). Denoie by x ihe numbei of dollais of coveiage.
a. Give ihe foimula foi hei expecied uiiliiy V(x) as a funciion of x.
SoiU1io: Given x, she faces ihe loiieiy in Figuie S13.
Figure S15
w L + x Px
(loss)
w Px
(no loss)
I
Hei expecied uiiliiy is
V(x) = u(w L + (I P)x) + (I )u(w Px) .
b. Suppose ihai u(z) = e
z
, = I/4, L = I00, and P = I/3. Wiiie V(x) using ihese values.
Teie should be ihiee vaiiables, x, and w. Find ihe opiimal value of x, as a funciion of and w,
by solving ihe isi-oidei condiiion (sei ihe deiivaiive of ihe expecied uiiliiy wiih iespeci io x equal io
zeio). (Te second-oidei condiiion foi ihis pioblem holds bui you do noi need io check ii.) Does ihe
opiimal amouni of coveiage inciease oi deciease in :
SoiU1io:
V(x) = (I/4)e
(wI00+2x/3)
(3/4)e
(wx/3)
V
(x) = (I/4)(2/3)e
(wI00+2x/3)
(3/4)(/3)e
(wx/3)
Solve V
(x) = 0:
(/6)e
(wI00+2x/3)
= (/4)e
(wx/3)
e
(I00+x)
= 3/2
(I00 + x) = log 3/2
x = (I/) log 3/2 + I00 .
Because (I/) log 3/2 < 0, ihis soluiion is increasing in . I.e., ihe moie iisk aveise
is ihe decision makei, ihe highei is ihe opiimal amouni of coveiage.
c. Repeai b, bui wiih P = I/6.
SoiU1io:
V(x) = (I/4)e
(wI00+3x/6)
(3/4)e
(wx/6)
V
(x) = (I/4)(3/6)e
(wI00+3x/6)
(3/4)(/6)e
(wx/6)
Solve V
(x) = 0:
(3/24)e
(wI00+3x/6)
= (/8)e
(wx/6)
e
(I00+x)
= 3/3
x = (I/) log 3/3 + I00 .
Since log 3/3 < 0, ihis soluiion is decreasing in .
d. You should nd ihai foi eiihei b oi c, ihe opiimal coveiage is incieasing in , and ihai in ihe oihei
case ii is decieasing in . Reconcile ihese iwo iesulis.
SoiU1io: When P = I/3, ihe insuiance is aciuaiially unfaii. Teiefoie, ihe DM
does noi gei full insuiance. Howevei, ihe moie iisk aveise is ihe DM, ihe moie she
is willing io ieduce ihe expecied value of hei wealih in ieiuin foi a ieduciion in
iisk, by geiiing moie insuiance.
When P = I/6, ihe insuiance is aciuaiially favoiable. Teiefoie, ihe DMchooses
io oveiinsuie ihe loss, as ihis is like iaking on a favoiable gamble. Te moie iisk
aveise is ihe DM, ihe less of ihis gamble she wanis, i.e., ihe less she oveiinsuies ihe
loss.
e. Te opiimal x in youi answeis io b and c should noi have depended on w. Why noi:
SoiU1io: Te uiiliiy funciion exhibiis consiani absoluie iisk aveision. Teie-
foie, iisk piefeiences aie noi aecied by changes in iniiial wealih.
f. Reiuin io ihe geneial scenaiio. We have shown ihai a decision makei wiih dieieniiable uiiliiy
should accepi some siake in a favoiable gamble. Using ihis faci, nd ihe condiiions on and L undei
which ihe opiimal level of coveiage is (i) gieaiei ihan L, (ii) equal io L, and (iii) less ihan L. Be cleai,
concise and explicit. You do noi need io iepiove ihe faci, and youi answei should noi involve any
dieieniiaiion oi even an expiession foi ihe decision makeis expecied uiiliiy.
SoiU1io: Full coveiage gives no iisk. Tis is opiimal when P = because ihe
insuiance is aciuaiially faii and ihe expecied value of ihe wealih is ihe same foi
all x. When P > , insuiance is aciuaiially unfaii and reducing coveiage fiom
full coveiage (x < L) is like iaking a siake in a favoiable gamble. When P < ,
insuiance is aciuaiially favoiable and increasing coveiage fiom full coveiage is like
iaking a siake in a favoiable gamble. We know ii is opiimal io iake some siake in a
favoiable gamble.
Moie expliciily, lei = xL, which is ihe amouni by which ihe DMoveiinsuies
( < 0 means undeiinsuiance). Ten ihe DMs loiieiy is ihe one she would face if
hei iniiial wealih weie w PL and she iook a siake in ihe gamble in Figuie S16.
Figure S16
I P
P
I
Te expecied value of ihis gamble is (I P) (I )P, which is less (iesp.,
gieaiei) ihan 0 if P > (iesp., P < ).
g. Whai does ihis pioblem iell you aboui wheihei, in piaciice, ii is iypically opiimal io gei full coveiage
foi a nancial loss:
SoiU1io: Insuiance is iypically aciuaiially unfaii because of ihe insuieis ad-
minisiiaiive cosis and piois. Hence, ii is iypically opiimal io undeiinsuie.
Exercise 6.9. In Exeicise 6.8, ihe moneiaiy loss has iwo possible values, 0 and L. Moie geneially,
ihe moneiaiy loss can be a iandom vaiiable z 0 wiih many possible posiiive values. Teie aie iwo
ways io exiend ihe idea of paiiial coveiage. One is io have coveiage ihai pays a fiaciion of each loss.
Te oihei is io have a deduciible , such ihai if z , ihe insuiance pays noihing, and if z > , ihe
insuiance pays z .
Suppose ihai ihe loss can be 0, $300 oi $900, each occuiiing wiih equal piobabiliiy. Compaie
an aciuaiially faii policy ihai coveis a fiaciion 1/2 of each loss wiih an aciuaiially faii policy ihai has a
deduciible of $300. Whai is ihe piemium chaiged in each case: Whai aie ihe ihiee possible ouicomes foi
each policy: Show ihai ihe policy wiih fiaciional coveiage is less iisky ihan ihe policy wiih a deduciible.
SoiU1io: Foi a policy ihai ieimbuises half of each loss, ihe piemiumis E[ z/2] =
200 and ihe nei losses aie as follows:
Loss 0 300 900
Reimbuisemeni 0 130 430
Piemium 200 200 200
Nei loss 200 330 630
Foi policy ihai has a $300 deduciible, ihe piemium is (I/3)(600) = 200, and
ihe nei losses aie as follows:
Loss 0 300 900
Reimbuisemeni 0 0 600
Piemium 200 200 200
Nei loss 200 300 300
Te isi is iiskiei ihan ihe second, as illusiiaied in Figuie S17.
Figure S17
200
1/3 2/3
350
1/2
650
1/2
200
1/3
500
2/3
Exercise 6.10. Tink a momeni aboui ihe following quesiion: Should a iisk-aveise moihei buy an
insuiance policy on hei sons life, if ihai policy is aciuaiially faii:
Well, you mighi ieason ihai ihe deaih of hei son is a iisk, and being iisk-aveise, she should buy
faii insuiance againsi ihis iisk.
Te pioblem wiih ihis ieasoning is ihai iisk aveision is dened wiih iespeci io uiiliiy ovei money
(oi some one-dimensional ouicome), and so we cannoi decide a piioii how a iisk-aveise peison will
iieai oihei iisks in hei life ihai give hei siaie-dependeni piefeiences ovei money.
Leis suppose ihai in addiiion io hei sons life/deaih, all ihe moihei caies aboui is money. Ten an
ouicomes can be wiiiien z, s, wheie z is an amouni of money, and s is eiihei
s
I
= son dies, oi
s
2
= son does noi die.
Lei u(z, s) be ihe moiheis VNM uiiliiy funciion.
s is also ihe siaie of ihe woild. Piefeiences ovei ouicomes as dened above aie siaie independeni
because ihe piefeience-ielevani aspecis of ihe siaie aie included in ihe ouicomes. Howevei, foi ihis ex-
eicise, ii is simplei io specify an ouicome as jusi money, and lei piefeiences be siaie dependeni. Ii will
also simplify ihe exeicise if we lei ihe ouicomes be nei iiansaciions. I will now adopi ihese inieipieia-
iions. Tis means ihai an aci is a paii z
I
, z
2
, wheie z
I
is ihe nei iiansaciion in siaie 1 and z
2
is ihe nei
iiansaciion in siaie 2.
Lei be ihe piobabiliiy ihai hei son dies. Suppose ihe moihei can buy a life insuiance policy on hei
son, which cosis dollais pei $1 of coveiage. I.e., buying uniis of insuiance cosis dollais, and pays
oui dollais if ihe son dies. Te policy is ihus aciuaiially faii. We can allow io be posiiive oi negaiive;
negaiive means ihai ihe moihei ieceives money when hei son lives and she pays ihe company when
hei son dies (leis hope ihe insuiance company will noi go oui of iis way io colleci on ihe policy).
In ihe quesiions below, V() is ihe moiheis expecied uiiliiy as a funciion of ihe level of coveiage.
a. If ihe moihei buys uniis of insuiance, whai aci does she face: Foi = I/3, diaw a piciuie of ihe
acis she can face as vaiies fiom -1,000 io 1,000. (Tis is paii of ihe budgei sei in ihe space of acis.)
SoiU1io: If ihe son dies, ihen ihe moihei ends up wiih ihe paymeni fiom ihe
insuiance company minus hei piemium : z
I
= . If ihe son does noi die,
ihen ihe moihei ends up wiih : z
2
= . E.g., if = I/3 and = 600, ihen
she faces ihe aci $400, $200.
Te giaph of hei budgei sei is ai end.
b. Suppose
u(z, s) = v(z) + w(s) ,
wheie v is a concave concave funciion. In woids, ihe maiginal uiiliiy of money is independeni of ihe
deaih of ihe son, and piefeiences ovei money exhibii iisk aveision.
Wiiie ihe foimula foi V(). Gioup ieims ihai depend on and ieims ihai do noi. How much
insuiance should ihe moihei buy:
(Be explicii in youi answei. Do not dierentiate. Tis involves basic ideas of iisk and iisk aveision
and does noi iequiie solving isi-oidei condiiions.)
Illusiiaie giaphically youi answei by diawing a possible indieience cuive in ihe space of acis
ihiough ihe opiimal aci in ihe budgei sei.
SoiU1io: Expecied uiiliiy given is
V() = (v( ) + w(s
I
)) + (I )(v() + w(s
2
))
= v( ) + (I )v() + w(s
I
) + (I )w(s
2
)
Oui pioblem is io nd ihai maximizes V(). A isi siep in any maximizaiion
pioblemis io gei iid of addiiive (and peihaps muliiplicaiive) consianis ihai jusi add
cluiiei. (I.e., if V() = U() + k, wheie k is a consiani ihai mighi depend on pa-
iameieis in ihe pioblem bui noi on , ihen ihe ihai maximizes U also maximizes
V, and vice-veisa. Doni make ihe misiake, howevei, of diopping ihe consiani when
U() = V( + k)!!) In ihis case, ihe w ieims aie addiiive and doni depend on ,
and so we can insiead maximize
v( ) + (I )v().
Tis is jusi ihe expecied uiiliiy, foi ihe siiicily concave uiiliiy funciion v, of ihe
loiieiy ihai pays wiih piobabiliiy and wiih piobabiliiy I . You
can veiify ihai ihe expecied value of ihis loiieiy is zeio foi any value of ; ihis is a
consequence of ihe faci ihai ihe insuiance is aciuaiially faii, and ihis loiieiy is jusi
ihe iiansaciions wiih ihe insuiance company. Teiefoie, ihe besi level of coveiage
is ihe one ihai minimizes iisk: = 0.
Te iniuiiion is ihai uiiliiy ovei money and ihe sons life aie independeni, and
buying insuiance jusi iniioduces iandomness in ihe money ihe moihei ieceives.
See guie ai end.
c. Suppose
u(z, s) = v(z + w(s)) ,
wheie v is concave, and w(s
2
) > w(s
I
). In woids, money and ihe sons life aie peifeci substitutes,
wiih ihe impuied moneiaiy value of ihe sons life equal io w(s
2
) w(s
I
). Because v is concave and
w(s
2
) > w(s
I
), ihe maiginal uiiliiy of money is higher when hei son dies.
Wiiie ihe foimula foi V(). Gioup ieims ihai depend on and ieims ihai do noi. How much
insuiance should ihe moihei buy:
(Be explicii in youi answei. Do not dierentiate. Tis involves basic ideas of iisk and iisk aveision
and does noi iequiie solving isi-oidei condiiions.)
Diaw a possible indieience cuive ihiough ihe opiimal aci in ihe budgei sei foi ihe case wheie
w(s
2
) = I000 and w(s
I
) = 200.
SoiU1io: Expecied uiiliiy given is
V() = v( + w(s
I
)) + (I )v( + w(s
2
)).
Tis is like ihe expecied uiiliiy of ihe following moneiaiy loiieiy
+ w(s
I
)
+ w(s
2
)
I
foi a decision makei wiih ihe siiicily concave uiiliiy funciion v.
Since ihe insuiance is aciuaiially faii, ihe expecied value of ihis loiieiy is w(s
I
)+
(I )w(s
2
), and hence does noi depend on ihe level of coveiage. Once again, we
musi nd ihe level of coveiage ihai minimizes ihe iisk of ihis loiieiy. We gei zeio
iisk if ihe iwo ouicomes aie ihe same, i.e., if:
+ w(s
I
) = + w(s
2
)
= w(s
2
) w(s
I
).
In ihis example, ihe loss of hei sons life is exacily ihe same in uiiliiy ieims as
a moneiaiy loss of w(s
2
) w(s
I
). Given ihai aciuaiially faii insuiance is available,
ihe moihei should gei full insuiance againsi ihis moneiaiy loss.
See guie ai end.
d. Suppose
u(z, s) = v(z)w(s) ,
wheie w(s
2
) > w(s
I
) > 0 and v is siiicily incieasing and concave. In woids, money and ihe sons life
aie complements. Te maiginal uiiliiy of money is lower when hei son dies.
Wiiie ihe foimula foi V. Assume ihai v is dieieniiable. Wiiie down ihe isi and second deiivaiives
of V. Show ihai V
() < 0, so ihai V is concave, and show ihai V
()|
=0
< 0. Does ihis imply ihai
ihe opiimal is posiiive oi negaiive: Explain. Diaw a plausible giaph of V ihai is consisieni wiih whai
you have found.
Diaw a possible piefeiied aci and a possible indieience cuive ihiough ihe aci.
SoiU1io:
V() = v((I ))w(s
I
) + (I )v()w(s
2
)
V
() = (I )v
( )w(s
I
) + (I )()v
()w(s
2
)
V
() = (I )
2
v
( )w(s
I
) + (I )()
2
v
()w(s
2
)
V
() < 0 because v
() < 0 (v is concave).
V
()|
=0
= (I )v
(0)w(s
I
) + (I )()v
(0)w(s
2
)
= (I )
.
+
v
(0)
.
+
(w(s
I
) w(s
2
))
.
< 0.
Te signs aie because (i) 0 < < I, (ii) v is incieasing, and (iii) w(s
2
) > w(s
I
).
Teiefoie, V is a concave funciion ihai is decieasing ai = 0. Ten ihe opiimal
musi be negaiive.
Heie is a plausible giaph of V. Te impoiiani feaiuies aie ihai V is concave,
and ihai ii is decieasing ai 0. Te maximum (if iheie is one) musi be io ihe lef of 0.
V()
See also guie ai end.

e. Considei ihe following ihiee cases:
1. Maiginal uiiliiy of money is highei in siaie s
I
ihan in siaie s
2
. In paiiiculai, u
(0; s
I
) > u
(0; s
2
).
2. Maiginal uiiliiy of money is ihe same in siaie 1 as in siaie 2. In paiiiculai, u
(0; s
I
) = u
(0; s
2
).
3. Maiginal uiiliiy of money is lowei in siaie 1 ihan in siaie 2. In paiiiculai, u
(0; s
I
) < u
(0; s
2
).
Foi each case, (i) nd ihe sign of V
()|
=0
, (ii) infei fiom ihis wheihei ihe opiimal amouni of insui-
ance is posiiive, and (iii) siaie wheihei ihe case applies io paii b, c, oi d.
SoiU1io: Fiom paii d, we see ihai ihe sign of V
()|
=0
is equal io ihe sign of
u
(0; s
I
) u
(0; s
2
). Hence, ii is posiiive in case 1, 0 in case 2, and negaiive in case
3.
Te opiimal amouni of insuiance in ihus posiiive in case 1, 0 in case 2, and
negaiive in case 3.
Case 1 applies io paii c, case 2 applies io paii b, and case 3 applies io paii d.
f. Which of ihese scenaiios seems moie likely: Whai would you do:
SoiU1io: Teie is no iighi answei io ihis quesiion. My own piefeiences aie
along ihe line of Pioblem d. Wiih a child I wani io do ihings ihai cosi money,
and I have io send ihe child io school, and so on, so ihai money and ihe child aie
complemenis.
g. Which case do you ihink besi is a man who doesni love oi even live wiih his wife bui ielies on hei
foi ihe salaiy she eains:
SoiU1io: Te wifes deaih would be ioughly equivaleni io a moneiaiy loss.
Exercise 6.11. We have consideied insuiing againsi a moneiaiy loss (e.g., life insuiance when fam-
ily membeis depend on ihe insuieds income, geiiing paiineis io shaie iisks in a business veniuie, dis-
abiliiy insuiance ihai pioiecis againsi losi income, liabiliiy insuiance ihai pioiecis againsi lawsuiis, shai-
ing ihe iiskiness of income wiih family membeis). Exeicise 6.10, we look ai insuiance when ihe iisk is
simply someihing ihai may aeci youi piefeiences ovei money (e.g., a childs deaih, geiiing a daie). In
ihis pioblem, we discuss insuiance when ihe iisk aecis youi uiiliiy fiom acquiiing a specic good. Ii
is ihe speciciiy of ihe good ihai makes us wani io model ihis dieienily fiom ihe pievious quesiion.
Examples:
Health insurance Te value of knee suigeiy depends on wheihei you have knee pioblems oi noi.
Auto collision insurance Te value of a cai iepaii oi a second cai depends on wheihei youi isi cai
geis damaged in an accideni.
Fire insurance Te value of iebuilding youi house oi buying a new one depends on wheihei youi
house buins down.
In ihe simplesi model, iheie aie iwo goods, x and y, such ihai youi uiiliiy fiom puichasing x is
aecied by some iisk, and y iepiesenis eveiyihing else. Assume ihai ihe VNM uiiliiy foi x and y is
sepaiable. I.e.,
u(x, y; s) = u
x
(x, s) + u
y
(y)
Lei iheie be iwo siaies, s
I
and s
2
. Siaie s
2
is when someihing bad happens ihai makes consumpiion
of good x moie impoiiani. Specically, suppose iheie is v(x) such ihai
u
x
(x, s
I
) = v(x)
u
x
(x, s
2
) = 2v(x).
Assume fuiihei ihai boih v and u
y
aie siiicily concave in x and y, iespeciively, and ihai ihey aie diei-
eniiable.
Finally, assume youi baseline income I is siaie independeni and ihai you can buy aciuaiially faii
insuiance ihai ieimbuises you in siaie s
2
.
You aie io show ihe following:
Consumpiion of y is ihe same in boih siaies.
Consumpiion of x is highei in siaie s
2
ihan in siaie s
I
.
Demand foi ihe insuiance is posiiive.
I will noi walk you ihiough ihe soluiion, bui I will give a few suggesiions on how io answei ihis
quesiion. Tink of ihis as a consumei choice pioblem wiih foui goods: x in siaie 1, x in siaie 2, y in siaie
1, y in siaie 2. Wiiie down ihe consumeis uiiliiy funciion ovei ihese foui goods, and ihe consumeis
budgei consiiaini. Te piices of ihese foui goods ihai appeai in ihe budgei consiiaini aie a funciion of
ihe piices of x and y (which aie noi siaie dependeni) and of ihe siaie piices.
You can ihen answei ihe isi iwo paiis of ihe quesiion using ihe faci ihai ai an opiimum, ihe
maiginal iaies of subsiiiuiion aie equal io ihe ielaiive piices. Tai is, foi goods k and j,
u/x
j
u/x
k
=
p
j
p
k
.
Dene any addiiional noiaiion ihai you use.
SoiU1io: Lei x
I
be consumpiion of good x in siaie s
I
and dene x
2
, y
I
and y
2
accoidingly. Lei
I
and
2
be ihe piobabiliiies of siaies s
I
and s
2
, iespeciively. Ten
expecied uiiliiy is
U(x
I
, x
2
, y
I
, y
2
) =
I
(v(x
I
) + u
y
(y)) +
2
(2v(x
2
) + u
y
(y)).
Lei I
I
be income speni in siaie 1 and lei I
2
be income speni in siaie 2. Lei p
I
and p
2
be ihe siaie piices. Ten ihe inieisiaie budgei consiiaini is
p
I
I
I
+ p
2
I
2
= p
I
I + p
2
I .
Wiihin ihe siaies ihe budgei consiiainis aie
p
x
x
I
+ p
y
y
I
= I
I
p
x
x
I
+ p
y
y
I
= I
2
Subsiiiuiing ihese inio ihe inieisiaie budgei consiiaini, ihe oveiall budgei con-
siiaini is
p
I
p
x
x
I
+ p
I
p
y
y
I
+ p
2
p
x
x
2
+ p
2
p
y
y
2
= p
I
I + p
2
I .
Foi example, ihe piice of good y in siaie 2 is p
2
p
y
. Since ihe insuiance is aciuaiially
faii, ihe siaie piices can be ihe piobabiliiies p
I
=
I
and p
2
=
2
. Ten ihe piices
of ihe goods aie
p
Ix
=
I
p
x
p
Iy
=
I
p
y
p
2x
=
2
p
x
p
2y
=
2
p
y
.
Te maiginal uiiliiies aie
du
dx
I
=
I
v
(x
I
)
du
dy
I
=
I
u
2
(y
I
)
du
dx
2
= 2
2
v
(x
2
)
du
dy
2
=
2
u
2
(y
2
).
Ten
du/dx
I
du/dx
2
=
p
Ix
p
2x
I
v
(x
I
)
2
2
v
(x
2
)
=

I
p
x
2
p
x
v
(x
I
) = 2v
(x
2
).
Since v
is decieasing, v
(x
I
) = 2v
(x
2
) implies ihai x
2
< x
I
. Foi y
I
and y
2
:
du/dy
I
du/dy
2
=
p
Iy
p
2y
I
u
2
(y
I
)
2
2
u
2
(y
2
)
=

I
p
y
2
p
y
u
2
(y
I
) = u
2
(y
2
).
Tis implies ihai y
I
= y
2
.
Since ihe value of consumpiionin siaie s
2
is highei ihan in siaie s
I
, ihe consumei
musi be buying insuiance.
Exercise 6.12. Considei a life insuiance policy ihai cosis p dollais pei dollai of coveiage. Te iele-
vani sei of siaies of ihe woild is {die, live]. We can ihink of ihe insuiance as an assei ihai pays $I in siaie
die and $0 in siaie live. Suppose ihai iheie is also a iiskless assei ihai cosis $1 and pays R dollais in
eiihei siaie. Assume ihai ihe iiskless assei can be sold shoii (i.e., ii is possible io iake oui bank loans).
a. Desciibe ihe poiifolio ihai has 1,000 uniis of insuiance and has zeio nei cosi. I.e., say how many
uniis of each assei aie in ihis poiifolio, and give ihe payo on ihe poiifolio in each siaie.
SoiU1io: 1000 uniis of insuiance cosi cosis p dollais. We have io sell p uniis of
ihe iiskless assei (iake oui a loan of p dollais) so ihai ihe nei cosi of ihe poiifolio is
zeio.
Te payo on ihis poiifolio is
Siaie Payo
die I000 pR
live pR
b. Explain, by way of an example, why ihe VNM model does noi apply io piefeiences ovei poiifolio
payos in ihis model.
SoiU1io: Piefeiences ovei ihe assei payos aie noi siaie-independeni. Tus, ihe
peison is inieiesied noi only in ihe disiiibuiionof ihe payos, bui in ihe coiielaiion
of ihe payos wiih ihe siaie. Foi example, if ihe iwo siaies have ihe same pioba-
biliiy, ihen a poiifolio ihai sells $1,000 uniis of ihe insuiance and buys p uniis of
ihe iiskless assei has ihe same piobabiliiy disiiibuiion on ihe payos as ihe poii-
folio desciibed eailiei, bui ihe peison would noi be indieieni beiween ihese iwo
poiifolios.
Befoie even geiiing io axioms, ihe VNM model assumes ihai piefeiences aie
dened ovei loiieiies, oi piobabiliiy disiiibuiions on ouicomes. We have shown
ihai ihis does noi hold heie.
Exercise 6.13. Suppose Bi has asked Bonnie oui foi a daie on Fiiday, and is awaiiing hei ieply.
He guies ihai Bonnie will accepi wiih piobabiliiy 1/3. In ihe meaniime, he negoiiaies wiih his faihei
foi some cash foi ihe daie. His faihei, who can nevei give a siiaighi answei, oeis him ihe following
opiions:
A If Bonnie accepis ihe daie, Bi geis $40. If Bonnie does noi accepi ihe daie, Bi geis $10.
B If Bonnie accepis ihe daie, Bi geis $13. If Bonnie does noi accepi ihe daie, Bi geis $24.
Showihai B second-oidei siochasiically dominaies A. Assuming ihai Bi is iisk aveise in his piefeiences
ovei money loiieiies, can we conclude ihai Bi would/should iake oei B: Why oi why noi: Whai is
ihe ielaiionship beiween ihis quesiion and ihe iheoiy of insuiance:
SoiU1io: B second-oidei siochasiically dominaies A because (i) ihe mean of B
is as highei ihan ihe mean of A (21 vs. 20) and ihe values B iakes on aie nesied
inside ihe values A iakes on (iemembei ihai ihis ciiieiion only woiks when each
iandom vaiiable iakes on only iwo values).
Noi geiiing a daie is a non-moneiaiy occuiience ihai neveiiheless aecis youi
uiiliiy fiom money. Teie is no coiieci answei as io whai you should do, heie aie
iwo possibiliiies:
You doni paiiiculaily caie aboui doing someihing else if you doni gei ihe daie,
bui if you do gei ihe daie, ihen you will wani io spend a deceni amouni of
money on ii. Te daie and money aie complemenis in ihis case, and so you
should piefei A ovei B (iecall ihai A gives you moie when Bonnie accepis ihe
daie, and B gives you less).
You weie planning on doing someihing wiih Bonnie ihai cosis liiile bui is a loi
of fun (whaievei ihai mighi be), bui if you doni gei ihe daie, ihen you will wani
io go oui diinking wiih ihe boys ai an expensive bai. In ihis case, ihe daie and
money aie subsiiiuies, and so you should piefei B ovei A.
Tis is a pioblem aboui siaie-dependeni piefeiences. Aciuaiially unfaii insui-
ance may be puichased when piefeiences ovei money siaie-dependeni.
Augusi 2006
Chapter 7
Markets for state-contingent contracts
Exercise 7.1. Whai is wiong (and whai is iighi) wiih ihe following: Opiions maikeis aie like gam-
bling hallswhai one peison wins, anoihei loses. Teiefoie, ihey aie socially wasieful, especially given
ihai ihey aie cosily io opeiaie.
SoiU1io: Main poini: Whai is impoiiani is expecied uiiliiy, noi expecied value.
Hence, even ihough ihe gambles aie unfavoiable, ihey mighi biing highei expecied
uiiliiy io ihe paiiicipanis.
Bui io ieceive full ciedii, you had io suggesi ihai ihe way opiions maikeis benei
iiadeis is by (i) shaiing iisk and/oi (ii) ieducing iisk. (Boih aie iiue.) You did noi
have io know exacily how opiions maikeis do ihis, howevei.
Exercise 7.2. Considei ihe Edgewoiih box in Figuie E7.1 foi siaie-coniingeni iiading beiween iwo
iiadeis wiih iwo siaies. Te dimensions of ihe Edgewoiih box iells you ihai ihe ioial wealih in siaies 1
and 2 is 26 and 16, iespeciively, bui oiheiwise you aie noi iold ihe iniiial allocaiion of wealih. Te oihei
infoimaiion you have is ihai boih iiadeis have siaie-independeni piefeiences, aie iisk aveise, and assign
ihe same piobabiliiies io ihe siaies.
Te following iwo quesiions aie ielaied, and ii will help you io ihink aboui ihem iogeihei. Youi
answei should include an explanaiion, and you should diaw on ihe giaph io illusiiaie ihe answei.
1. Wiih jusi ihis infoimaiion, whai can you iell me aboui ihe equilibiium allocaiion: (Tai is, you
should be able io ideniify a iegion in ihe box wheie ihe equilibiium allocaiion musi lie).
2. Suppose ihai I iell you ihai ihe piobabiliiies of ihe iwo siaies aie equal. Whai can you iell me aboui
ihe ielaiive siaie piices:
Exercise 7.3. You can iake uniis in ihis pioblem io be in millions of dollais.
Suppose ihai an invesimeni oppoiiuniiy maiuies in one yeai and pays $1 wiih piobabiliiy 9/10 and
$0 wiih piobabiliiy 1/10. Te piois of ihe invesimeni aie iniiially owned by a single individual, bui
ihai individual has decided io sell ihe oppoiiuniiy io invesiois, foi whaievei ieason. Foi simpliciiy,
suppose ihai ihe ownei issues a single inniiely-divisible shaie, whose endogenous maikei piice is p
(i.e., p dollais geis you owneiship of ihe eniiie ieiuin on ihe invesimeni). Suppose ihai iheie is one
oihei iiskless assei whose ieiuin pei dollai invesied is exacily $1 and whose piice is xed exogenously
ai $1. Te buyeis of ihe im will sell ihis iiskless assei (boiiow money) in oidei io pay foi ihe shaies
of siock and ihe sellei of ihe im will buy ihis iiskless assei (loan money) wiih ihe pioceeds of ihe sale
of ihe siock. (Tai is, iheie is no consumpiion in ihe peiiod in which ihe iiading occuis.)
Suppose ihai iheie aie N iisk-aveise invesiois wiih ihe same CARA uiiliiy funciion u(z) = e
z
.
We can ignoie ihe invesiois iniiial wealih because wiih CARA uiiliiy wealih does noi aeci iisk piefei-
ences.
a. Lei V(, p) be an invesiois expecied uiiliiy when puichasing uniis of ihe assei ai piice p.
Solutions for Chapter 7 (Markets for state-contingent contracts) 2
Figure E7.6. Graph for Exercise 7.2.
0
2
4
6
8
I
0
I
2
I
4
I
6
I
8
2
0
2
2
2
4
0 2 4 6 8
I
0
I
2
I
4
4
3
M
o
n
e
y
S
t
a
t
e
1
M o n e y S t a t e 2
K
e
y
s
e
r
0
2
4
6
8
I
0
I
2
I
4
I
6
I
8
2
0
2
2
2
4
0 2 4 6 8
I
0
I
2
I
4
4
3
M
o
n
e
y
S
t
a
t
e
1
Money State 2
S
o
z
e
Solutions for Chapter 7 (Markets for state-contingent contracts) 3
SoiU1io: If puichasing ai piice p, p uniis of ihe iiskless assei aie sold. Te
ieiuin in ihe good siaie is p, and ihe ieiuin in ihe bad siaie is p. Te
expecied uiiliiy is
V(, p) = .9e
(Ip)
.Ie
p
.
b. Lei (p) be each invesiois demand foi ihe assei, as a funciion of ihe piice. Deiive (p) by dif-
feieniiaiing V(, p) wiih iespeci io and solving ihe isi-oidei condiiion. (You do noi need io check
ihe second-oidei condiiion.) Youi answei should give as a funciion of p and , and should have a
logaiiihm.
SoiU1io:
.9(I p)e
(Ip)
.Ipe
p
= 0
9(I p)e
(Ip)
= pe
p
log(9(I p)) (I p) = log(p) + p
=
I
log(9(I p)/p).
c. Te equilibiium condiiion is ihai N(p) = I. Fiom ihis condiiion, solve foi p as a funciion of N
and .
SoiU1io: Te equilibiium condiiion is
N
log(9(I p)/p) = I
log(9(I p)/p) =

N
9(I p)/p = e
/N
p =
9
e
/N
+ 9
d. Show ihai (foi xed N) as 0, i.e., as ihe invesiois become moie iisk neuiial, ihe piice incieases
io 9/I0, which is ihe expecied ieiuin on ihe assei.
SoiU1io: As 0, e
/N
I, and hence p 9/I0.
e. Show ihai (foi xed > 0) as N , i.e., as iheie aie moie and moie invesiois, ihe piice incieases
io 9/I0.
SoiU1io: As N , e
/N
I, and hence p 9/I0.
f. Whai does ihis say aboui wheihei laige, publically iiaded coipoiaiions aie less iisk aveise ihan
individually owned companies:
SoiU1io: By spieading iisks oui among many invesiois, laige, publically iiaded
coipoiaiions aie less iisk aveise ihan individually owned companies.
Augusi 2006
Chapter 8
Asset Markets
Exercise 8.1. Te aiiached giaphs showan Edgewoiih box wiih agenis Keysei and Soze, foi an assei
maikei wiih iwo siaies s
I
and s
2
and no consumpiion in peiiod 0. Te endowmeni and ihe indieience
cuives ihiough ihe endowmeni aie diawn. Boih iiadeis aie have siaie-independeni piefeiences and aie
iisk aveise.
SoiU1io: See Seciion 4.2.8 of ihe leciuie noies.
a. Whai is ihe endowmeni of each iiadei: Which iiadei(s) have a iisky endowmeni:
b. On ihe isi giaph, label which indieience cuive belongs io Soze and which belongs io Keysei.
c. On ihe isi giaph, diaw ihe budgei line when siaie piices aie equal. Maik ihe opiimal allocaiion
fiom ihe budgei line foi each of ihe iiadeis, and illusiiaie ihe opiimaliiy by diawing ihe indieience
cuive of each iiadei ihiough his/hei opiimal allocaiion.
d. Refeiiing io ihe giaph io suppoii youi aigumeni, explain why, foi ihe given endowmenis and foi
any iisk-aveise piefeiences, equal siaie piices cannoi be equilibiium siaie piices, and ihai equilibiium
siaie piices musi saiisfy p
2
/p
I
> I.
e. Te equilibiium siaie piices foi ihe piefeiences I am using aie appioximaiely p
2
/p
I
= 2, and ihe
equilibiium allocaiions aie appioximaiely z
k
= II, 8.3 and z
s
= I3, 7.3. Diaw ihe budgei line foi
ihese piices, maik ihe equilibiium allocaiions, and diawplausible indieience cuives showing ihai ihese
allocaiions aie opiimal foi each iiadei. Whai is each iiadeis poiifolio ieiuin:
f. Suppose iheie aie iwo asseis, a and b. Assei as payo is 1 in each siaie, and assei bs payo is I
is siaie s
I
and 3 in siaie s
2
. Given ihe equilibiium siaie piices and allocaiions siaied above, deiive ihe
equilibiium assei piices and poiifolios.
g. Suppose ihai insiead, assei as payo is 1 in siaie s
I
and 0 in siaie s
2
, and assei bs payo is 0 in siaie
s
I
and 1 in siaie s
2
. Deiive ihe equilibiium assei piices and poiifolios.
Exercise 8.2. In ihe geneial case of binomial opiion piicing:
1. Te piice of ihe bond and ihe siock aie q
I
and q
2
, iespeciively;
2. Te payo of ihe bond is Rq
I
in boih siaies, wheie R is ihe iiskless ieiuin;
3. Te payo of ihe siock is R
L
q
b
in siaie 1 and R
H
q
b
in siaie 2, wheie R
L
< R
H
, R
L
is ihe ieiuin in
ihe bad siaie, and R
H
is ihe ieiuin in ihe good siaie.
4. Te piice of ihe call opiion on ihe siock is q
3
and ihe siiike piice is K, wheie R
L
q
2
< K < R
H
q
2
.
Deiive ihe no-aibiiiage piice of ihe opiion as a funciion of q
I
, q
2
, R, R
H
, R
L
and K.
Solutions for Chapter 8 (Asset Markets) 2
SoiU1io: Te payo of ihe call opiion is R
H
q
2
K in siaie 2 and 0 in siaie 1.
Hence, ihe maiiix of payos is
Payos
Assei I Assei 2 Assei 3
Siaie 1 Rq
I
R
L
q
2
0
Siaie 2 Rq
I
R
H
q
2
R
H
q
2
K
Te poiifolio
I
,
2
of ihe bond and ihe siock wiih ihe same payo as ihe call
opiion is ihe soluiion io
I
Rq
I
+
2
R
L
q
2
= 0
I
Rq
I
+
2
R
H
q
2
= R
H
q
2
K.
Te soluiion is
I
=
R
H
q
2
K
R
H
R
L
R
L
Rq
I
2
=
R
H
q
2
K
(R
H
R
L
)q
2
.
Teiefoie,
q
3
= q
I
I
+ q
2
2
=
R
H
q
2
K
R
H
R
L
R
L
R
+
R
H
q
2
K
R
H
R
L
=
R
H
q
2
K
R
H
R
L
_
I
R
L
R
_
.
Exercise 8.3. Considei a model of an assei maikei in which iheie aie 2 siaies (1 and 2) and 2 asseis
(a and b) wiih ihe following payos:
Payos
Assei a Assei b
Siaie 1 1 3
Siaie 2 2 1
a. Veiify ihai ihe assei piices q
a
= q
b
= 3 aie no-aibiiiage piices by calculaiing ihe siaie piices.
b. Giaph ihe eniiie sei of no-aibiiiage piices. Explain whai you aie doing, and specify wheihei ihe
boundaiy of ihe iegion you diaw is in ihe sei of no-aibiiiage piices.
c. Suppose ihai you leain ihai a iiadeis baseline wealih is $12 in siaie 1 and $10 in siaie 2, and, afei
liquidaiing hei poiifolio, she has an allocaiion of $16 in siaie 1 and $8 in siaie 2. Calculaie hei poiifolio.
Exercise 8.4. Tis is a iwo-siaie example of aibiiiage piices. Suppose ihai iheie is a iiskless bond
wiih payo of $1 in each siaie, and a iisky siock wiih a payo of $2 in siaie 1 and $3 in siaie 2.
a. Diaw a giaph showing ihe sei of no-aibiiiage piices foi ihese iwo asseis.
SoiU1io: Lei ihe iiskless bond be assei a and ihe iisky siock be assei b. Te
maiiix of payos is
Payos
Assei a Assei b
Siaie 1 1 2
Siaie 2 1 3
Te sei of no-aibiiiage piices is ihe shaded aiea in Figuie S18 (noi including ihe
boundaiy).
Figure S18
Ya (I),

Y
b
(I)
Ya (2),

Y
b
(2)
I 2 3
I
2
3
4
3
Asset a
Asset b
b. Suppose iheie is also a call opiion on ihe siock, wiih a siiike piice of $3, which gives ihe buyei ihe
opiion of acquiiing ihe siock (wiih dividend) foi $3. Whai aie ihe payos of ihis assei: Whai poiifolio of
ihe bond and ihe siock give ihe same payos: Whai is ihe no-aibiiiage piice of ihe opiion, as a funciion
of ihe piices of ihe bond and ihe siock:
SoiU1io: Te payo of ihe call opiion is:
Y
c
= max{

Y
b
3, 0 ,
oi 0 in siaie 1 and 2 in siaie 2.
Te poiifolio
a
,
b
of ihe bond and ihe siock wiih ihe same payo as ihe call
opiion is ihe soluiion io:
a
+
b
2 = 0
a
+
b
3 = 2.
Te soluiion is
a
= 4/3 and
b
= 2/3.
Teiefoie, ihe piice of ihe call opiion is
q
c
= (2/3)q
a
(4/3)q
b
.
Augusi 2006
Chapter 9
Contracting with Hidden Actions
Exercise 9.1. Considei ihe following pioblem of moial hazaid beiween a piincipal and an ageni
(e.g., an employei and an employee). Te ageni woiks on a piojeci ihai may iesuli in a gioss pioi io ihe
piincipal of eiihei 1600 oi 2300. Te ageni can exeii low oi high eoii, denoied e
L
and e
H
, iespeciively.
If low, ihe piobabiliiy ihai ihe gioss pioi is 2300 is equal io 1/2; if high, ihai piobabiliiy is 8/9.
Te piincipal is iisk neuiial. Te ageni is an expecied-uiiliiy maximizei who is iisk aveise wiih
iespeci io money. His uiiliiy when ieceiving wage w and exeiiing eoii e is
u(w, e) =
w
I/2
if e = e
L
w
I/2
3 if e = e
H
.
Te puipose of ihis exeicise is io deiive ihe eniiie sei of ecieni coniiaci. Tis iequiies ihe use
of numeiical sofwaie. Te main concepis ihis exeicise illusiiaies aie ihe consiiainis ihai dene ihe
isi-besi and second-besi coniiacis.
a. Calculaie ihe expeci gioss pioi wiih low eoii and wiih high eoii.
SoiU1io: Te expecied pioi foi low eoii is
(I/2)I600 + (I/2)2300 = $2, 030.
Te expecied pioi foi high eoii is
(I/9)I600 + (8/9)2300 = $2, 400.
b. Ploi ihe fioniiei of ihe sei of low-eoii coniiacis and of ihe sei of high-eoii coniiacis foi ihe
case wheie iheie is no moial hazaid (in uiiliiy space, i.e., woikeis expecied uiiliiy on one axis, and ihe
employeis expecied nei piois on ihe oihei axis). Show youi calculaiion.
SoiU1io: Lei (w
H
, w
L
, e) be ihe expecied piois of ihe employei as a funciion
of ihe wage paid in ihe high and low ouicomes and ihe eoii level. Tai is,
(w
H
, w
L
, e
L
) = (I/2)(2300 w
H
) + (I/2)(I600 w
L
)
(w
H
, w
L
, e
H
) = (8/9)(2300 w
H
) + (I/9)(I600 w
L
).
Solutions for Chapter 9 (Contracting with Hidden Actions) 2
Lei U(w
H
, w
L
, e
L
) be ihe expecied uiiliiy of ihe employee as a funciion of ihe
wages and eoii level. I.e.,
U(w
H
, w
L
, e
L
) = (I/2)w
I/2
H
+ (I/2)w
I/2
L
U(w
H
, w
L
, e
H
) = (8/9)(w
I/2
H
3) + (I/9)(w
I/2
L
3)
No moial hazaid implies ihai ecieni coniiacis pay ihe same amouni in boih
siaies (since ihe employei is iisk neuiial and ihe employee is iisk aveise). Lei w be
ihe wage ihai is paid. Ten, inveiiing U foi ihe low eoii level, we gei ihai
u = (I/2)w
I/2
+ (I/2)w
I/2
u
2
= w
I.e., ihe wage as a funciion of uiiliiy is w(u, e
L
) = u
2
. Subsiiiuiing ihis inio , we
gei
(w(u, e
L
), w(u, e
L
), e
L
) = (I/2)(2300 u
2
) + (I/2)(I600 u
2
)
= 2030 u
2
Tus, we can wiiie piois as a funciion of ihe employees uiiliiy given low eoii as
(u, e
L
) = 2030 u
2
Now leis do ihe same foi ihe high eoii level:
u = (8/9)(w
I/2
3) + (I/9)(w
I/2
3)
(u + 3)
2
= w
I.e., w(u, e
H
) = (u + 3)
2
, and ihus
(w(u, e
H
), w(u, e
H
), e
L
) = (8/9)(2300 (u + 3)
2
) + (I/9)(I600 (u + 3)
2
)
= 2400 (u + 3)
2
= (u, e
H
)
Figuie S19 shows ihe plois of (u, e
L
) and (u, e
H
), which aie ihe ecieni
fioniieis foi ihe seis of low and high-eoii coniiacis, iespeciively, when iheie is no
moial hazaid.
Figure S19
I0 20 30 40 30
300
0
300
I000
I300
2000
2300
u
In ihis example, ovei ihe iange of ihe ploi, ihe eciency fioniiei foi high-eoii
coniiacis lies above ihe fioniiei foi low eoii coniiacis, and hence ihe high-eoii
fioniiei is ihe oveiall eciency fioniiei.
c. Repeai ihe lasi quesiion foi ihe case of moial hazaid.
SoiU1io: Te fioniiei foi low-eoii coniiacis does noi change, because ihe in-
ceniive consiiaini is noi binding foi low-eoii coniiacis.
Foi high-eoii coniiacis, we nd solve ihe inceniive compaiibiliiy and individ-
ual iaiionaliiy consiiainis, leaving ihe ieseivaiion uiiliiy u as a paiameiei. Recall
ihai ihese consiiainis weie:
(I/9)w
I/2
F
+ (8/9)w
I/2
S
3 = u (S10)
(I/2)w
I/2
F
+ (I/2)w
I/2
S
= u (S11)
By equaiion (S11), w
I/2
F
= 2u w
I/2
S
, and so ihe isi equaiion becomes:
(I/9)(2u w
I/2
S
) + (8/9)w
I/2
S
= u + 3
w
I/2
S
= u + 27/7
w
S
= (u + 27/7)
2
Tus,
w
I/2
F
= 2u (u + 27/7)
w
I/2
F
= u 27/7
w
I/2
F
= (u 27/7)
2
Tus, piois as a funciion of uiiliiy is
(u, e
H
) = (I/9)(I600 (u 27/7)
2
) + (8/9)(2300 (u + 27/7)
2
)
= 2400 (I/9)(u 27/7)
2
(8/9)(u + 27/7)
2
Figuie S20 shows ihe plois of (u, e
L
) and (u, e
H
), which aie ihe ecieni
fioniieis foi ihe seis of low and high-eoii coniiacis, iespeciively, when iheie is
moial hazaid.
Figure S20
I0 20 30 40 30
300
0
300
I000
I300
2000
2300
u
In ihis example, ovei ihe iange of ihe ploi, ihe eciency fioniiei foi high-eoii
coniiacis lies above ihe fioniiei foi low eoii coniiacis, and hence ihe high-eoii
fioniiei is ihe oveiall eciency fioniiei.
d. Suppose ihai, if no coniiaciing iakes place, ihen ihe piincipals pioi is 0 and ihe agenis uiiliiy is 30.
On a sepaiaie giaph, ploi ihe sei of individually iaiional and ecieni coniiacis boih wiih and wiihoui
moial hazaid.
SoiU1io: Shaded aiea is sei of feasible and individually iaiional coniiacis. Solid
fioniiei is sei of individually iaiional and ecieni coniiacis.
Te case wiihoui moial hazaid is shown in Figuie S21
Figure S21
I0 20 30 40 30
300
0
300
I000
I300
2000
2300
u
Te case wiih moial hazaid is shown in Figuie S22.
Figure S22
I0 20 30 40 30
300
0
300
I000
I300
2000
2300
u
e. Pick a poini in ihe inieiioi of ihe sei of IR and ecieni coniiacis wiihoui moial hazaid (neiihei
paiiy geis all ihe gains fiom iiade). Now suppose ihai we swiich io a iegime wiih moial hazaid. Indicaie
which IR and ecieni coniiacis wiih moial hazaid make boih paiiies woise o ihan undei ihe oiiginal
ouicome you picked.
SoiU1io: Tis is haid io do foi ihis example because ihe eciency fioniieis wiih
and wiihoui moial hazaid aie so close iogeihei. I will use a blow up of ihe e-
ciency fioniieis, shown in Figuie S23.
Figure S23
33.I 33.2 33.3 33.4
930
940
u
x
Te giay line is ihe fioniiei wiihoui moial hazaid, and ihe black line is ihe
fioniiei wiih moial hazaid.
Te poinis wheie ihe shaded iegion inieisecis ihe fioniiei wiih moial hazaid
aie woise ihan x foi boih paiiies.
Exercise 9.2. Whai is wiong (and whai is iighi) wiihihe following: Basing ieacheis pay onsuipiise
classioom inspeciions oi ihe iesulis of siudeni exams is exploiiive. Teacheis should siiongly iesisi ihis
when negoiiaiing iheii coniiacis.
SoiU1io: Adding an exiia measuie foi evaluaiing peifoimance helps ieduce
moial hazaid (i.e., if ieacheis eoii is noi obseivable, and pay is noi iied io siu-
deni peifoimance, ieacheis will woik a subopiimal amouni, hence will have lowei
pioduciiviiy ihan is opiimal). Hence, ii incieases ihe poieniial gains fiom iiade. (If
such moniioiing is cosiless) ii should be possible io come up wiih a new coniiaci
ihai involves moniioiing and ihai makes boih ieacheis and ihe school adminisiia-
iion beiiei o.
Exercise 9.3. Assume, in Exeicise 9.1, ihai ihe woikei (you) has a ieseivaiion uiiliiy of 30 uniis,
and ihai ihe employei geis all ihe gains fiom iiade.
a. Suppose iheie is no moial hazaid. Whai coniiaci would ihe piincipal oei if he could gei all ihe
gains fiom iiade:
SoiU1io: Te coniiacis musi pay a xed wage, equal io ihe minimum wage ihai
gives ihe ageni his ieseivaiion uiiliiy.
Besi high eoii coniiaci: Wage w solves u(w, e
h
) = 30, i.e., w
I/2
= 33. Soluiion
is w = $I, 089. Expecied nei pioi is 2400 I089 = $I, 3II.
Besi low eoii coniiaci: Wage w solves u(w, e
L
) = 30, i.e., w
I/2
= 30. Soluiion
is w = $900. Expecied nei pioi is 2030 900 = $I, I30.
Tus, high eoii coniiaci is ihe besi oveiall coniiaci.
b. Suppose iheie is moial hazaid. Whai coniiaci would ihe piincipal oei if he could gei all ihe gains
fiom iiade:
SoiU1io: Besi low eoii coniiaci, in ihe piesence of moial hazaid, is ihe same
low eoii coniiaci we found wiihoui moial hazaid.
Besi high eoii coniiaci is e
H
, w
S
, w
F
, wheie w
S
and w
F
aie ihe wages paid
when ihe gioss piois aie high and low, iespeciively. Tese musi saiisfy ihe incen-
iive compaiibiliiy and individual iaiionaliiy consiiainis:
(I/9)u(e
H
, w
F
) + (8/9)u(e
H
, w
S
) (I/2)u(e
L
, w
F
) + (I/2)u(e
L
, w
S
) (S12)
(I/9)u(e
H
, w
F
) + (8/9)u(e
H
, w
S
) 30 (S13)
We nd ihe wages ihai saiisfy ihese equaiions wiih equaliiy. I.e., we solve ihe
sysiem:
(I/9)w
I/2
F
+ (8/9)w
I/2
S
3 = 30
(I/2)w
I/2
F
+ (I/2)w
I/2
S
= 30
Tis is a sysiemof lineai equaiions in w
I/2
S
and w
I/2
F
. By ihe second equaiion, w
I/2
F
=
60 w
I/2
S
, and so ihe isi equaiion becomes:
(I/9)(60 w
I/2
S
) + (8/9)w
I/2
S
= 33.
Te soluiion is w
I/2
S
= 33.86, and so w
I/2
F
= 26.I4, w
S
= II46.3, and w
F
= 683.3.
Te expecied wage is (I/9)683.3 + (8/9)II46.3 = $I, 093, and so ihe expecied
nei piois aie 2400 I093 = $I, 303. Piois aie highei ihan undei ihe low eoii
coniiaci, and so ihis is ihe besi oveiall coniiaci (given ihai iheie is moial hazaid).
Exercise 9.4. Reinieipiei Exeicise 9.1 as an example moial hazaid in insuiance maikeis. You aie
buying insuiance againsi ihe ihef of money fiom youi house. Suppose ihai iheie is some chance ihai
someone will eniei youi house and sieal $900 ihai you have lying aiound. Youi ioial wealih is $2,300.
If you siay home all ihe iime (high level of caie, e
H
) ihe piobabiliiy of a ihef is I/9. If you go oui ofen
(low level of caie, e
L
), ihe piobabiliiy of ihef is I/2. Youi uiiliiy fiom money w and ihe level of caie is
u(w, e) =
w
I/2
if e = e
L
w
I/2
3 if e = e
H
.
a. Whai is ihe expecied loss foi each of ihe iwo levels of caie.
SoiU1io: Wiih high level of caie: (I/9)900 = $I00.
Wiih low level of caie: (I/2)900 = $430.
b. Assume ihai ihe insuiance companies make zeio piois, so ihai you gei all ihe gains fiom iiade.
Whai is ihe besi coniiaci you can design (i.e., whai is ihe level of caie, ihe level of coveiage, and ihe
piemium) if iheie is no moial hazaid:
SoiU1io: A coniiaci species ihe level e of caie, ihe ieimbuisemeni x in case of
a loss, and ihe piemium p: e, x, p.
Ecieni coniiacis musi have full insuiance. Given ihe zeio-pioi assumpiion,
ihe piemiumis ihe expeciedloss. Tis leaves only ihe level of caie io be deieimined.
Besi high caie coniiaci is e
H
, $900, $I00. You end up wiih $2,400 income foi
suie. Expecied uiiliiy given ihis coniiaci is
u(e
H
, 2400) = 2400
I/2
3 = 43.99.
Besi low caie coniiaci is e
L
, $900, $430. You end up iwih $2,030 income foi
suie. Expecied uiiliiy given ihis coniiaci is
u(e
L
, 2030) = 2030
I/2
= 43.28.
Teiefoie, ihe high caie coniiaci siaied above is ihe besi.
c. Is ihis policy inceniive compaiible if ihe insuiance companies cannoi obseive wheihei you leave ihe
house alone:
SoiU1io: No, because you aie fully insuied and you end up wiih ihe same in-
come iegaidless of youi aciion.
d. Wiih moial hazaid, whai is ihe opiimal coniiaci you can design which has as a clause ihai you go
oui ofen:
SoiU1io: Te same coniiaci, e
L
, $900, $430, as wiihoui moial hazaid, since
ii is noi necessaiy io piovide special inceniives io iake ihe low level of caie.
e. Wiih moial hazaid, whai is ihe opiimal coniiaci you can design which has as a clause ihai you
siay home: (Ii suces io give ihe equaiions ihai dene ihe opiimal coniiaci.)
SoiU1io: Te coniiaci is e
H
, x, (I/9)x, wheie ihe level of coveiage x is ihe
highesi foi which ihe inceniive compaiibiliiy consiiaini,
(I/9)u(e
H
, 2300 900 + (8/9)x) + (8/9)u(e
H
, 2300 (I/9)x)
(I/2)u(e
L
, 2300 900 + (8/9)x) + (I/2)u(e
L
, 2300 (I/9)x), (S14)
is saiised.
We nd x ihai saiises (S14) wiih equaliiy; i.e., we solve ihe equaiion:
(I/9)((I600 + (8/9)x)
I/2
3) + (8/9)((2300 (I/9)x)
I/2
3)
= (I/2)(I600 + (8/9)x)
I/2
+ (I/2)(2300 (I/9)x)
I/2
.
You aie noi asked io solve ihis equaiion. If you wanied io do so, you could
solve ii numeiically (e.g., use Mathematicas FindRoot funciion). You can also solve
ii aiiihmeiically; by ieaiianging, squaiing, ieaiianging and squaiing again, you
obiain a quadiaiic equaiion. Te soluiion is $191.4.
Te uiiliiy fiom ihis coniiaci is
(I/9)(I600 + (8/9)I9I.4)
I/2
+ (8/9)(2300 (I/9)I9I.4)
I/2
3 = 43.93,
which is highei ihan ihe uiiliiy fiom ihe low eoii coniiaci. Tus, ihis is ihe besi
oveiall coniiaci.
Exercise 9.5. A fiiend has asked you io sneak a six-pack of beei foi him inio a conceii. Being ihe
kind of fiiend ihai you aie, you cannoi be iiusied noi io diink ihe beei youiself jusi befoie going inio ihe
conceii. Unfoiiunaiely, if you do noi diink ihe beei, ihen iheie is some possibiliiy (1/10) ihai ihe beei
will be conscaied by secuiiiy on youi way in. Tus, if you show up wiih no beei, youi fiiend cannoi
iell wheihei you diank ihe beei oi ii was conscaied. (Remembei, ihis is ciion.) You aie going io oei
a deal io youi fiiend wheie ihe fee youi fiiend pays foi youi seivice depends on wheihei you delivei ihe
beei. Heie aie ihe impoiiani ihings you need io know in oidei io design an opiimal coniiaci:
1. Youi uiiliiy if you gei x dollais oui of ihis iiansaciion is
u(x) =
e
.2x
if you doni diink ihe beei
e
.2(x+3)
if you diink ihe beei.
(x is posiiive if you ieceive a paymeni fiom youi fiiend and negaiive if you pay money io youi
fiiend.) Tus (i) you aie iisk aveise, wiih consiani absoluie iisk aveision, and (ii) beei and money
aie peifeci subsiiiuies, wiih ihe six-pack being equivaleni io $3.
2. Youi fiiends uiiliiy if she geis x dollais oui of ihis iiansaciion is
v(x) =
x if she doesni diink ihe beei.

x + 3 if she diinks ihe beei befoie ihe conceii
x + 8 if she diinks ihe beei in ihe conceii
(x is posiiive if she ieceives a paymeni fiom you and is negaiive if she pays money io you.) Tus (i)
youi fiiend is iisk neuiial, and (ii) beei and money aie peifeci subsiiiuies, wiih beei being equivaleni
io $8 if diunk in ihe conceii and $3 if diunk befoie ihe conceii.
a. Suppose youi fiiend will accepi any deal you oei hei foi which hei expecied uiiliiy is ai leasi 3,
which is whai she would gei if she iejecied youi deal and jusi diank ihe beei befoie ihe conceii.
Wiiie down ihe iwo equaiions whose soluiion gives ihe opiimal coniiaci. (OPTIONAL: Solve ihe
iwo equaiions numeiically.)
SoiU1io: Te coniiaci species ihe paymeni w
S
you ieceive when you delivei
ihe beei, and ihe paymeni w
F
you ieceive when you do noi delivei ihe beei. Te iwo
inequaliiies aie ihe inceniive compaiibiliiy consiiaini and youi fiiends individual
iaiionaliiy consiiaini:
.9(e
.2w
S
) + .I(e
.2w
F
) e
.2(w
F
+3)
(IC)
.9(8 w
S
) + .I(w
F
) 3 (IR)
Te soluiion io ihese equaiions (when ihey hold wiih equaliiy) is w
S
= 4.8I and
w
F
= I.23.
b. Suppose ihe baigaining powei is shifed io youi fiiend. She makes a iake-ii-oi-leave-ii oei, and
you accepi ihe deal as long as youi expecied uiiliiy is ai leasi I (i.e., e
0
), which is whai you would
gei if you didni make any deal wiih youi fiiend. Wiiie down ihe iwo equaiions whose soluiion gives
ihe opiimal coniiaci foi youi fiiend. (Tis iime, if you wiiie ihe equaiions piopeily, you can solve ihem
easily.) Whai is ihe isi-besi coniiaci, and how do ihe isi-besi and second-besi coniiacis compaie in
ieims of ihe expecied uiiliiy ihai you and youi fiiend gei:
SoiU1io: Te iwo inequaliiies aie ihe inceniive compaiibiliiy consiiaini and
youi own individual iaiionaliiy consiiaini:
.9(e
.2w
S
) + .I(e
.2w
F
) e
.2(w
F
+3)
(IC)
.9(e
.2w
S
) + .I(e
.2w
F
) I (IR)
We make ihese equaliiies, and solve ihe iwo equaiions. Te iwo imply ihai e
.2(w
F
+3)
=
I, and so (iaking logs) .2(w
F
+ 3) = 0. Hence, w
F
= 3. Fiom (IR),
.9(e
.2w
S
) + .I(e
.2(3)
) = I
e
.2w
S
= (I .Ie)/.9 = 0.809
.2w
S
= log(0.809) = 0.2I2
w
S
= I.06
In ihe isi-besi coniiaci, ii is obseivable wheihei ihe beei is diunken oi con-
scaied, and so ihai agieemeni can iequiie ihai ihe beei be deliveied. Te paymeni
is consiani because ihe iisk-neuiial paiiy should beai all ihe iisk. Te paymeni is
ihe soluiion io youi individual iaiionaliiy consiiaini:
e
.2(w)
= I.
Hence, w = 0.
Youi uiiliiy is I in boih ihe isi-besi and second-besi coniiacis, because ii is
assumed heie ihai youi fiiend geis all ihe gains fiom iiade. Youi fiiends uiiliiy is
highei foi ihe isi-besi ihan foi ihe second-besi agieemenis:
Case Uiiliiy
1si-besi .9(8) + .I(0) = 7.2
2nd-besi .9(8 I.06) + .I(0 (3)) = 6.73
Augusi 2006
Chapter 10
Monopolistic screening with hidden valuations
Exercise 10.1. New Jeisey siaie law piohibiis self-seivice gas. Te following example of monopo-
lisiic scieening may be ielevani!
In ihe following, imagine ihai gas is noi a divisible good; e.g., a consumei eiihei geis a ll up oi
does noi.
Suppose ihai a iown has a single gas siaiion. Considei ihe piicing decisions of ihis gas siaiion, iaking
ihe piices of gas in ihe suiiounding iowns as xed. Suppose ihai iheie aie iwo iypes of consumeis, fiugal
and lazy. Te lazy consumeis will pay up io $1.20 pei gallon, wheieas ihe fiugal ones will pay up io $1.00
pei gallon. (Te dieience lies in ihe willingness of ihe consumeis io diive io a neighboiing iown in
oidei io save money.) Te cosi of gas, including opeiaiing expenses, foi ihe gas siaiion is $.90 pei gallon.
a. If ihe siaiion can chaige dieieni piices io fiugal and lazy cusiomeis (e.g., because all fiugal cus-
iomeis diive Hyundai and and all lazy ones diive Meicedes), whai piices will ii chaige io each iype:
SoiU1io:
b. Suppose insiead ihai ihe gas siaiion cannoi disiinguish beiween a fiugal and lazy consumei. (Sup-
pose also ihai ii is illegal foi ihe gas siaiion io oei self-seivice gasoline.) Whai piices mighi ihe gas
siaiion chaige, and whai infoimaiion would you need io know io deieimine which piice is opiimal:
SoiU1io:
c. Suppose again ihai ihe siaiion cannoi iell who is fiugal and who is lazy, bui ihe siaiion can oei
self-seivice gasoline. Fuiiheimoie, suppose ihai self-seive gas is an inconvenience io ihe cusiomei, bui
is noi any cheapei foi gas siaiions io piovide. Suppose ihai fiugal cusiomeis aie willing io pay up io $.01
pei gallon foi full seive, wheieas lazy cusiomeis aie willing io pay up io $.10 pei gallon foi full seive.
(Noie: Te insuiance example siudied in class is concepiually closely ielaied, bui I have simplied
ihis pioblem by allowing only iwo levels of inconvenience, full-seive and self-seive, which would be
analogous io allowing only iwo levels of coveiage in ihe insuiance example.)
1. Foi each of ihe following piicing siiaiegies, nd a beiiei piice siiaiegy and explain why ii is beiiei:
(a) Full-seive: $1.13. Self-seive: $.99.
(b) Full-seive: $1.06. Self-seive: $.99.
2. Ten nd ihe opiimal piicing siiaiegy, among ihose wiih which ihe siaiion sells boih full and self-
seive gasoline. Specify foi which consumeis ihe self-seleciion consiiaini is binding and foi which
consumeis ihe individual iaiionaliiy consiiaini is binding.
3. Who is beiiei o and who is woise o (among fiugal cusiomeis, lazy cusiomeis, and ihe gas siaiion),
compaied io when self-seive gasoline is noi allowed:
Augusi 2006
Chapter 11
Screening with adverse selection
Exercise 11.1. Considei ihe following pioblem of adveise seleciion in insuiance maikeis. Teie
aie iwo iypes of people looking foi auiomobile liabiliiy insuiance, good diiveis and bad diiveis. Foi
simpliciiy, suppose ihe siaies ioiie law says ihai foi any accideni, no maiiei whai kind, ihe paiiy ai fauli
pays ihe oihei paiiy $90,000. Bad diiveis have an accideni ai which ihey aie ai fauli wiih piobabiliiy 1/3.
Good diiveis have an accideni ai which ihey aie ai fauli wiih piobabiliiy 1/10. Te uiiliiy ovei money
foi boih iypes is u(m) = m
I/2
, and ihe iniiial wealih foi boih iypes is $230, 000.
Te maikei foi insuiance is peifecily compeiiiive and iheie aie no adminisiiaiive cosis.
a. Suppose ihai ihe insuiance companies can obseive which people aie high iisk and which aie low
iisk. Desciibe ihe maikei equilibiium. (I.e., whai kind of coniiaci will each iype gei:) Explain.
SoiU1io: Given ihai ihe insuiance maikei is peifecily compeiiiive and iheie
aie no adminisiiaiive cosis, ihe insuiance piemiums aie aciuaiially faii, and so
each iype geis full insuiance. Te high iisk peoples piemium is (I/3)$90, 000 =
$30, 000. Te low-iisk peoples piemium is (I/I0)$90, 000 = $9, 000.
b. Whai does ii mean foi iheie io be adveise seleciion in ihis pioblem: If iheie is adveise seleciion,
whai would happen if ihe insuiance companies oeied ihe iwo coniiacis you found in ihe pievious paii:
SoiU1io: Teie is adveise seleciion if ihe insuiance companies cannoi obseive
which people aie high iisk and which aie low iisk. If ihe insuiance companies
oeied ihe iwo coniiacis desciibed above, ihen eveiyone, high iisk and low iisk,
would iake ihe low-iisk policy since ihe piemium is lowei. Te aciuaiial iisk ihe
insuiance companies faced would ihen exceed ihe piemium chaiged.
c. Suppose ihai iheie is adveise seleciion. Whai is ihe besi menu of coniiacis (fiom ihe insuieds
poini of view), wiih a disiinci coniiaci foi each iype of diivei, such ihai (i) each diivei chooses his oi
hei coiiesponding coniiaci and (ii) each coniiaci is aciuaiially faii foi ihe designaied iype. (You can
siop ai ihe poini wheie you have given an equaiion ihai deieimines ihe key piovision of ihe coniiaci, oi
you can solve ihe equaiion and give ihe exaci coniiaci.)
SoiU1io: High-iisk iypes gei full insuiance, ai a piemium (1/3)$90,000. Te
pioblem is io nd ihe coniiaci foi ihe low-iisk iypes ihai is ihe besi foi low iisk
iypes subjeci io ihe consiiaini ihai ihe high-iisk iypes piefei iheii own coniiaci.
Solutions for Chapter 11 (Screening with adverse selection) 2
Lei x be ihe coveiage of ihe low-iisk iypes. Te aciuaiially faii piemiumfoi ihis
level of coveiage given ihai only ihe low-iisk iypes accepi ihe coniiaci is (I/I0)x.
Now in oidei io induce self-seleciion, we have io sei ihe level of coveiage low
enough ihai ihe high-iisk iypes piefei iheii full coveiage coniiaci ovei ihe low-iisk
iypes coniiaci, even ihough ihe piemium foi iheii coniiaci is based on a piobabil-
iiy (1/3) of a loss, while ihe piemium foi ihe low-iisk iypes coniiaci is based on a
piobabiliiy (1/10) of a loss.
Te self-seleciion consiiaini is:
High-iisk iypes uiiliiy fiom accepiing high iisk coniiaci
High-iisk iypes uiiliiy fiom accepi low iisk coniiaci.

Maihemaiically:
u(230, 000 30, 000)
= (2/3)u(230, 000 .Ix) + (I/3)u(230, 000 90, 000 + .9x) (S19)
Since ihe equilibiium coniiacis should give ihe low-iisk iypes as much as uiiliiy as
possible, subjeci io ihe self-seleciion consiiaini, we wani io nd ihe highesi x such
ihai (S19) is saiised. Tai is, we nd x by solving:
220, 000
I/2
= (2/3)(230, 000 .Ix)
I/2
+ (I/3)(I60, 000 + .9x)
I/2
Te soluiion is 7806.
d. Explain ihe meaning of a menu of coniiacis and self-seleciion in ihe coniexi of ihis pioblem.
SoiU1io: Insuiance companies do noi aciually oei a lisi of coniiacis, wiih ihe
ieims on one side and chaiacieiisiics of ihose who should iake each coniiaci on
ihe lef. Tey do oei a vaiieiy of coniiacis, bui ihey doni boihei lisiing who geis
whai coniiaci since ihey cannoi veiify ihe chaiacieiisiics of ihe cusiomeis anyway
(ihe same way a legal coniiaci dieis fiom an implicii coniiaci). Howevei, when
oeiing ihe coniiacis, ihe companies do guess whai kind of people will accepi each
one when ihey calculaie ihe aciuaiial iisk of ihe coniiaci and ihe piemium ihai
should be chaiged. Self-seleciion means ihai ihe insuied paiiies aciually do accepi
ihe designaied coniiacis because ii is in iheii inieiesi io do so.
Exercise 11.2. Considei ihe following pioblem of adveise seleciion in insuiance maikeis. Teie
aie iwo iypes of people looking foi healih insuiance, high iisk and low iisk. Te insuiance is io covei
ihe cosi of back suigeiy, which each iype will have peifoimed no maiiei whai, if ihe need aiises. Te
opeiaiion cosis $12,000. High iisk people will need ihe suigeiy ovei ihe yeai-long life of ihe policy wiih
piobabiliiy 1/2. Low iisk people will need ii wiih piobabiliiy 1/10. Te fiaciion of ihe populaiion ihai
is low iisk is I/2. Te uiiliiy ovei money foi boih iypes is u(m) = m
I/2
, and ihe iniiial wealih foi boih
iypes is $24, 000 (i.e., wiihoui insuiance, ihey have $24,000 when ihey do noi need suigeiy, and ihey
have $12,000 when ihey need suigeiy).
Te maikei foi insuiance is peifecily compeiiiive and iheie aie no adminisiiaiive cosis.
When answering the questions below, explain the steps you are taking in nding the solution.
a. Suppose ihai ihe insuiance companies can obseive which people aie high iisk and which aie low
iisk. Desciibe ihe maikei equilibiium. (I.e., whai iype of coniiacis will each iype gei:)
SoiU1io: Given ihai ihe insuiance maikei is peifecily compeiiiive and iheie aie
no adminisiiaiive cosis, ihe insuiance piemiums aie aciuaiially faii, and so each
iype geis full insuiance. Te high iisk peoples piemiumis (I/2)$I2, 000 = $6, 000.
Te low iisk peoples piemium is (I/I0)$I2, 000 = $I, 200. Foi compaiison, noie
ihai ihe low iisk peoples uiiliiy is ihus u(22, 800) I3I, and ihe high iisk peoples
uiiliiy is u(I8, 000) I34
b. Now nd ihe sepaiaiing maikei equilibiium if ihe insuieis cannot obseive who is high oi low iisk.
You should specify ihe high-iisk coniiaci, and nd ihe low-iisk coniiaci as a soluiion io ihe self-seleciion
consiiaini. (You will have io solve an equaiion wiih squaie ioois on boih sides. You can solve ii numei-
ically, oi you can solve ii by ieaiianging, squaiing boih sides, ieaiianging, squaiing boih sides again,
ieaiianging, and solving ihe iesuliing quadiaiic equaiion.)
SoiU1io: Lei C
H
and C
L
be ihe coniiacis foi high and low-iisk iypes, iespec-
iively. Tese aie chaiacieiized by:
C
H
provides full coverage: x
H
= I2, 000.
C
L
and C
H
are actuarially fair: p
H
= 6, 000 and p
L
= .Ix
L
.
High-risk types self-selection constraint holds with equality:
V
H
(C
H
) = V
H
(C
L
)
u(I8000) = .3u(24000 p
L
) + .3u(I2000 + x
L
p
L
)
Subsiiiuiing p
L
= .Ix
L
inio ihis equaiion, using ihe squaie iooi uiiliiy funciion,
and ihen solving foi x
L
:
I8000
I/2
= (I/2)(24000 .Ix)
I/2
+ (I/2)(I2000 + .9x)
I/2
Tis can be solved by ieaiianging, squaiing boih sides, ieaiianging, squaiing boih
sides again, ieaiianging, and solving ihe iesuliing quadiaiic equaiion, oi by solving
ii numeiically. Te answei is x I042.
c. Show ihai if ihe coniiacis you found above aie in ihe maikei, ihen ihe faii pooling coniiaci does
noi aiiiaci all ihe consumeis.
SoiU1io: Now you aie asked io check ihai ihe pooling coniiaci does noi dom-
inaie ihis self-seleciion menu; ihis is a necessaiy condiiion foi ihis self-seleciion
menu io be a compeiiiive equilibiium. We know ihe high-iisk iypes piefei ihe
pooling coniiaci. We have io compaie ihe uiiliiy of ihe low-iisk iypes foi ihe iwo
coniiacis.
Uiiliiy foi ihe pooling coniiaci, which has a piemium of
(I/2)(I/2)I2000 + (I/2)(I/I0)I2000 = 3600
is
u(24000 3600) = 20400
I/2
= I43.
Uiiliiy foi ihe faii, sepaiaiing coniiaci is
(9/I0)(24000 I04)
I/2
+ (I/I0)(I2000 + I042 I04)
I/2
= I30
Tus, ihe pooling coniiaci is noi piefeiied by low-iisk individuals.
d. Lei be ihe fiaciion of people in ihe maikei ihai aie low-iisk. We sei ihis io 1/2 befoie, bui now
we wani io iieai ii as a paiameiei. How does youi answei io ihe pievious pioblem depend on :
SoiU1io: Te faii self-seleciion menu does noi depend on , bui wheihei ihe
pooling coniiaci dominaies does. Te aciuaiially faii piemiumfoi ihe pooling con-
iiaci is
(I/I0)$I2, 000 + (I )(I/2)$I2, 000 = p()
Suppose ihai is close io one. Ten ihis piemium is close io ihe piemium ihe low
iisk iypes would pay foi full insuiance if iheie weie noi any adveise seleciion ai all,
and so ihe uiiliiy fiom ihis coniiaci would exceed ihe uiiliiy ihe low iisk iypes gei
fiom ihe sepaiaiing menu of coniiacis we found above. Tai means ihai ihe sep-
aiaiing menu cannoi be an equilibiium, because some insuiance company would
come in and oei ihis pooling coniiaci, which boih iypes piefei io ihe menu (cei-
iainly ihe high iisk iypes ieally like ihis coniiaci, since ihey gei ihe same coveiage
ai a lowei piemium). By chaiging a slighily highei piemium, ihe company could
make a pioi and so would have an inceniive io oei an alieinaie coniiaci.
Te cuio level of such ihai ihe low-iisk iype is jusi indieieni beiween ihe
pooling coniiaci and ihe faii, sepaiaiing menu is ihe soluiion io
u(24000 p()) = (9/I0)u(24000 .Ix
L
) + (I/I0)u(I2000 + .9x
L
)
Subsiiiuiing in p() and x
L
:
(24000 ((I/I0)I2000 + (I )(I/2)I2000))
.3
= (9/I0)(24000 .I(I042))
.3
+ (I/I0)(I2000 + .9(I042))
.3
Te soluiion is .97.
Augusi 2006
Chapter 12
Hidden information after contracting
Exercise 12.1. Suppose ihai iheie is no insuiance.
a. Whai is ihe allocaiion of suigeiy: (Tai is, foi whai values of do you gei suigeiy: Is ii ecieni
(yes oi no):
SoiU1io: You pay ihe full cosi I/2 of suigeiy, and hence choose suigeiy when
> I/2. Tis is an ecieni allocaiion of suigeiy.
b. Whai is ihe funciion s():
SoiU1io: Given also ihai iheie aie no piemiums oi ieimbuisemeni, youi suiplus
is I when I/2 and you choose noi io gei suigeiy, and ii is II/2 when > I/2
and you choose io pay 1/2 foi ihe suigeiy. Tai is:
s() =
I I/2
I/2 > I/2,
c. Foi ihe discieie case, whai is ihe expecied suiplus E[s()]: Whai is youi expecied uiiliiy E[u(s())]:
SoiU1io: Te suiplus is 7/8 when = I/8, 3/8 when = 3/8, and 1/2 when
= 3/8. Hence,
E[s()] = (I/3)(7/8) + (I/3)(3/8) + (I/3)(I/2) = 2/3 (S20)
E[u(s()] = (I/3)(7/8)
I/2
+ (I/3)(3/8)
I/2
+ (I/3)(I/2)
I/2
.8II0. (S21)
Exercise 12.2. As a benchmaik, we should siudy ihe isi-besi (ex-anie ecieni) allocaiion ihai
iesulis when iheie is no hidden infoimaiion afei coniiaciing. Suppose, ihen, ihai iheie is insuiance and
ihai an insuiance coniiaci can specify paymeni coniingeni diiecily on (iaihei ihan simply coniingeni
on wheihei you decide io gei suigeiy).
Whai is youi opiimal insuiance coniiaci in ihe discieie case: Is ihe allocaiion of suigeiy ecieni:
Whai is youi expecied uiiliiy:
SoiU1io: Te allocaiion of suigeiy should be ecieni, and ihe expecied suiplus
should be ihe maximized value s
= 2/3 calculaied inExeicise c. You should beai no

iisk, which means ihai youi insuiance should leave you wiih s
foi suie. Teiefoie,

youi uiiliiy is u(2/3) = (2/3)
I/2
.8I63.
Solutions for Chapter 12 (Hidden information after contracting) 2
Te coniiaci ihai implemenis ihis pays you 1/2 when > I/2, and when
< I/2. Te piemium is I/3.
Comment Now ieiuin io ihe case wheie iheie is insuiance bui also ihe hidden
infoimaiion aboui . Te coniiacis can only specify a piemium p and a ieimbuise-
meni x io be paid if someone chooses io gei suigeiy. Suppose, howevei, ihai doc-
iois can costlessly obseive , and iheyfoi whaievei ieasonsonly peifoimsuigeiy
when I/2. Tus, ihe allocaiion of suigeiy is ex-posi ecieni. To gei iid of all
iisk, you need io be ieimbuised foi ihe back pioblems you pui up wiih even when
ihey aie noi seveie enough foi suigeiy. Tis is noi possible. Hence, ihe allocaiion
cannoi be ex-anie ecieni. Tis inabiliiy io insuie iisk is one of ihe consequences
of ihe hidden infoimaiion. Te oihei consequence is ihai any insuiance will disioii
ihe decision io have suigeiy, leading also io a misallocaiion of suigeiy.
Exercise 12.3. Now suppose ihai ihe insuiance companies cannoi obseive , and dociois give
suigeiy io you whenevei you demand ii.
a. Lei S(x) equal E[s()] when ihe ieimbuisemeni foi suigeiy is x. Giaph S(x) foi x beiween 0 and
1/2. Tis is a siep funciion. Explain how you found S. (You do noi need io deieimine ihe piemium
as a funciion of x foi ihis pioblem. Since ihe insuiance companies eain zeio expecied piois, you can
calculaie ihe expecied suiplus foi a xed allocaiion of suigeiy by ignoiing any paymenis io/fiom ihe
insuiance companies.)
SoiU1io: Heie is ihe giaph:
I/8 I/4 3/8 I/2
I/2
3/8
2/3
Foi 0 x I/8, you gei suigeiy only when = 3/8. Hence, expecied suiplus
is ihe maximum value 2/3 calculaied above.
Foi I/8 < x 3/8, you gei suigeiy only when = 3/8 oi = 3/8. Hence,
expecied suiplus is
(I/3)(7/8) + (2/3)(I/2) .623.
Foi 3/8 < x I/2, you always gei suigeiy. Hence, suiplus is 1/2.
b. Heie is a ploi of S foi ihe unifoim case:
0.1 0.2 0.3 0.4 0.5
0.52
0.54
0.56
0.58
0.6
0.62
Give ihe iniuiiion aboui why ii is monoionically decieasing, and why iis slope is zeio ai x = I/2.
SoiU1io: Ii is monoionic because incieasing x incieases ihe misallocaiion of
suigeiy; foi highei x you demand suigeiy foi moie values of below 1/2.
Iniuiiively, iis slope is zeio ai x = 0 because ihe misallocaiion ihai iesulis when
people wiih close bui less ihan I/2 is veiy small. Tese aie ihe people who choose
io gei suigeiy when x is small. Foi example, when x incieases fiom 0 io .01, people
wiih beiween .49 and .3 choose io gei suigeiy. Foi such a peison, ihe loss in
suiplus is ai mosi .01. Howevei, when x incieases fiom .49 io .3, ihe eeci is ihai
people wiih beiween 0 and .01 choose io gei suigeiy. Foi such a peison, ihe loss
in suiplus is ai leasi .49.
Exercise 12.4. Explain why, when seaiching foi an opiimal value of x foi ihe discieie case, we can
immediaiely eliminaie values oihei ihan 1/8, 3/8 and 1/2. (You can also eliminaie 1/2, bui ii is haidei io
see ai ihis poini.)
SoiU1io: As long as we aie noi aecied ihe allocaiion of suigeiy, we wani io
piovide as much insuiance as possible io ieduce iisk. E.g., moving fiom x = I/4
io x = 3/8 does noi disioii ihe allocaiion of suigeiy, bui does inciease insuiance.
Hence, x = 3/8 dominaies x = I/4.
Exercise 12.5. Given ihai ihe piemium is aciuaiially faii (ii is equal io ihe piobabiliiy of suigeiy
iimes x), nd ihe piemium in ihe discieie case foi x equal io 0, 1/8, 3/8 and 1/2.
SoiU1io: When x = 0, ihe piemium is zeio. When x = I/8, ihe piobabil-
iiy of ihe ieimbuisemeni is ihe piobabiliiy ihai = 3/8, and hence ihe expecied
ieimbuisemeni is (I/3)(I/8) = I/24. Similaily, ihe piemium when x = 3/8 is
(2/3)(3/8) = I/4, and ihe piemium when x = I/2 is 1/2.
Exercise 12.6. Find ihe funciion s() and expecied uiiliiy E[u(s())] in ihe discieie case foi x
equal io 0, 1/8, 3/8 and 1/2. Whai is ihe opiimal value of x:
SoiU1io: Expecied uiiliiies:
s()
x = I/8 = 3/8 = 3/8 E[u(s())]
0 I I/8 = 7/8 I 3/8 = 3/8 I I/2 = I/2 .8II0
I/8 I I/8 I/24 = I/3 I 3/8 I/24 = 7/I2 I I/2 + I/8 I/24 = 7/I2 .8I33
3/8 I I/8 I/4 = 3/8 I I/2 + 3/8 I/4 = 3/8 I I/2 + 3/8 I/4 = 3/8 .7906
I/2 I/2 I/2 I/2 .707I
Te opiimal value of x is x=1/8.
Exercise 12.7. Find ihe welfaie loss due io ihe misallocaiion of suigeiy and ihe welfaie loss due io
ihe misallocaiion of iisk, foi x equal io 0, 1/8, 3/8 and 1/2.
SoiU1io: Welfaie loss io due misallocaiion of suigeiy and iisk:
x s
u(s
) E[s()] u(E[s()]) E[u(s())] u(s
) u(E[s()]) u(E[s()] E[u(s())]

0 2/3 .8I63 2/3 .8I63 .8II0 0 .0033
I/8 2/3 .8I63 2/3 .8I63 .8I33 0 .0020
3/8 2/3 .8I63 3/8 .7907 .7906 .0238 .000I
I/2 2/3 .8I63 I/2 .707I .707I .I094 0
Exercise 12.8. Iniuiiively, decieasing x decieases ihe misallocaiion of suigeiy bui incieases ihe
misallocaiion of iisk. Te opiimal x is ihe one ihai balances ihese iwo eecis. Foi ihe unifoim case,
heie is ihe ploi of ihe welfaie loss due io ihe misallocaiion of suigeiy, as a funciion of x:
0.1 0.2 0.3 0.4 0.5
0.02
0.04
0.06
0.08
Heie is a ploi of ihe welfaie loss due io ihe misallocaiion of iisk, as a funciion of x:
0.1 0.2 0.3 0.4 0.5
0.001
0.002
0.003
0.004
0.005
0.006
Heie is ihe ploi of ihe expecied uiiliiy as a funciion of x:
0.1 0.2 0.3 0.4 0.5
0.74
0.76
0.78
Te maximum value is .783 ai x = .042.
You have alieady explained why ihe welfaie loss io ihe misallocaiion of suigeiy has slope of zeio ai
x = 0. Explain why ihe slope of ihe welfaie loss due io ihe misallocaiion of iisk is zeio ai x = I/2. Aigue
ihai iheiefoie ihe opiimal value of x musi lie siiicily beiween 0 (no insuiance) and 1/2 (full insuiance).
SoiU1io: Ai x = I/2, eveiyone geis suigeiy, and iheie is no iisk. Wiih dieien-
iiable uiiliiy, people aie locally iisk neuiial, and so ihe maiginal cosi of iisk is 0. Foi
example, in ihe lasi ploi, ihe slope of ihe cosi of iisk is 0 ai x = I/2. On ihe oihei
hand, since S(x) has non-zeio slope ai x = I/2, decieasing x below 1/2 incieases
expecied uiiliiy.
On ihe oihei hand, S
(0) = 0, and so ihe maiginal cosi of allocaiion eciency

is 0 ai x = 0. Te maiginal cosi of iisk is non-negligible, since ai x = 0 eveiyone is
incuiiing iisk.
Exercise 12.9. Dene (noi chaiacieiize) ex-posi eciency, in ihe coniexi of ihis model.
SoiU1io: A feasible ouicome is ex-posi ecieni if iheie is no oihei feasible oui-
come ihai makes eveiy peison, whaievei iheii pioduciiviiy , as well oi beiiei o.
Tis is Paieio eciency, wiih people piefeiences given iheii obseivaiion of .
Exercise 12.10. Dene (noi chaiacieiize) ex-anie eciency, in ihe coniexi of ihis model.
SoiU1io: An feasible ouicome is ex-anie ecieni if iheie is no oihei feasible
ouicome ihai gives eveiyone as high oi highei expecied uiiliiy (befoie knowing
iheii ).
Foi ihe iecoid:
Can individual beai any iisk in an ex-anie ecieni ouicome in ihis model:
No. Because iheie is no aggiegaie unceiiainiy (ihe aveiage suiplus is always
known) and because individuals aie siiicily iisk aveise, all iisk musi be shaied in
ex-anie ecieni allocaiions.
Exercise 12.11. Suppose ihai the government cannot observe peoples productivity, and insiead can
only obseive iheii income (i.e., ihe amouni of ouipui ihey pioduce). In piinciple, a iax scheme could
be any funciion (y) of ouipui, bui foi simpliciiy leis look only ai lineai iax schemes. I.e., each peison
geis a lump-sum iiansfei t and is iaxed fiaciion of ouipui. Given t and , a peison wiih pioduciiviiy
who woiks x ends up wiih a nei suiplus of
(I )2
I/2
x
I/2
x + t
Find x(, ), ihe amouni a peison wiih pioduciiviiy chooses io woik when ihe iax iaie is (we
doni woiiy aboui t because ii does noi aeci ihe peisons maximizaiion pioblem).
SoiU1io: Find x(, ) ihai solves:
max (I )2
I/2
x
I/2
x + t
Siaiing and solving ihe f.o.c.:
(I )
I/2
x
I/2
I = 0
x = (I )
2

Exercise 12.12. Now you could calculaie t(), ihe aveiage iax as funciion of ihe iax iaie , and
ihen subsiiiuie ihis foi t io deieimine s(, ), ihe suiplus a peison of iype ends up wiih when ihe iax
scheme is . Ten you could also calculaie S(), ihe aveiage suiplus when ihe iax scheme is . Howevei,
I will wiiie s and S foi you:
s(, ) = (I )
2
+ (I )
S() = I/2(I
2
)
Whai do s and S iepieseni io a peison in ex-anie ieims: Looking only ai s, foi whai value of is
iheie no iisk:
SoiU1io: s, as a funciion of a iandom vaiiable , is iiself a iandom vaiiable.
s(, ) is ihus ihe loiieiy (wiih ouicomes in suiplus) each household faces befoie
leaining iis iype, and given ihai ihe iax scheme is , and given ihai ihe household
will choose iis woik level opiimally upon leaining . S() is ihe mean of ihis loiieiy.
Teie is no iisk if and only if s(, ) is ihe same foi all . Tis is iiue if and only
if = I.
Foi ihe iecoid (you weieni asked io calculaie ihis):
t () = E[(I )] = (I )
2
/2.
s(, ) = (I )2
I/2
x()
I/2
x() + t ()
= (I )2
I/2
((I )
2
)
I/2
(I )
2
+ (I )
2
/2
= 2(I )
2
(I )
2
+ (I )
= (I )
2
+ (I )
S() = E[s(, )]
= E[(I )
2
+ (I )]
= (I/2)(I )
2
+ (I )
= (I/2)(I 2 +
2
) +
2
= I/2(I
2
)
Exercise 12.13. Now we can look ai ihe iiade-o beiween ex-posi eciency and iisk. Foi each ,
s(, ) is unifoimly disiiibuied. Mean-vaiiance analysis is legiiimaie wiih unifoim disiiibuiions, jusi as
ii is wiih noimal disiiibuiions. Tis means ihai, foi a xed uiiliiy funciion u ovei ouicomes (suiplus),
we can wiiie expecied uiiliiy as a funciion U(,
2
), wheie and
2
aie ihe mean and vaiiance of ihe
unifoimly disiiibuied loiieiies ovei suiplus, and
U
> 0 and
U
2
< 0. and
2
can be wiiiien as
funciion () and
2
() of , and so we can wiiie ihe expecied uiiliiy as a funciion
V() = U((),
2
()).
Heie aie plois of () and
2
():
0 I
()
0 I
2
()
(Tese aie noi on ihe same scale. You do noi need io know ihe scale io answei ihe quesiion.)
Use ihese plois io
discuss ihe iiade-o beiween ex-posi ineciency and ex-anie iisk,
io aigue ihai ihe opiimal (ihe ex-anie ecieni (second-besi)) is siiicily gieaiei ihan 0 and siiicily
less ihan I, and
io discuss ihe following claim:
Unemploymeni compensaiion ieduces ihe inceniive foi ihe unemployed io nd woik,
leading io ineciency. Ii should iheiefoie be abolished.
SoiU1io: Te isi paii was woiih 6 poinis, bui almosi no one ieceived ihe full
size poinis because I iook o 1 oi 2 poinis if you did noi explain why lowei mean
lowei ex-posi eciency. Te ieason is ihai if ihe aveiage suiplus is highei, ii is
possible io disiiibuie ii in such a way ihai makes ihe ex-posi uiiliiy highei foi eveiy
iype (eveiy ), and hence ii is possible io come up wiih an ex-posi Paieio supeiioi
allocaiion (assuming ihai ihe means by which suiplus is disiiibuieddoes noi disioii
inceniives and change ihe aveiage suiplus available).
Mosi coiiecily ideniied ihai () was a measuie of ex-posi eciency, which
is decieasing in , and
2
() is a measuie of ex-anie iisk, which is also decieasing
in . Since
U
> 0 and
U
2
< 0, when goes up, ihe deciease in iisk has a posiiive
eeci bui ihe deciease in expecied suiplus (ihe expecied value of ihe loiieiy people
face) has a negaiive eeci. Tis is ihe iiade-o.
Te second paii was woiih 3 poinis. You should have expliciily noied ihai ai
= I, maiginal iisk is zeio bui maiginal expecied suiplus is siiicily negaiive, and
hence decieasing fiom 1 incieases uiiliiy, while ai = 0, maiginal iisk is siiicily
negaiive bui maiginal expeciedsuiplus is 0, and hence incieasing fiom0 incieases
uiiliiy.
An even moie maihemaiical aigumeni was also accepiable: Maiginal cosi of
allocaiion ineciency ai = 0 is zeio since
d
d
() =
d
d
()(0) = 0
Noie also ihai
d
2
d
() = (I )
3
/3.
Oveiall,
V
(0) =
U
2
((I )
3
/3) > 0.
Maiginal cosi of iisk is zeio ai = I since
d
2
d
(I) = 0
Oveiall,
V
(I) =
U
() < 0.
Te ihiid paii was woiih 3 poinis. You had io noie ihai ihis is basically an exam-
ple of ihe maihemaiical model in ihe pioblem. Hence, ii is iiue ihai unemploymeni
compensaiion disioiis inceniives and hence leads io ex-posi ineciency, ii also de-
cieases iisk. As shown in ihe pioblem, ihe opiimal level of compensaiion, i.e., ihai
which maximizes ex-anie expecied uiiliiy is gieaiei ihan 0 and less ihan 1 (i.e., less
ihan full wage)
Augusi 2006
Chapter 13
Signaling
Augusi 2006
Chapter 14
Long-termversus short-termcontracting

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Economics of Uncertainty and Information Timoihy Van Zandi

be ihe loiieiy obiained by ieplacing ihe lef-hand bianch of ihe

is piefeiied io NOTPAY(1), ihen

is piefeiied io PAY(1). Teie-

, and ihen PAY(4)

degiee line jusi as in class.)

2z z < $I, 000

line by diawing a vecioi peipendiculai

( x)] < E[ x]E[u

( x)] = (E[ x]+E[ y])E[u

> 0, ihis implies u

(y) and simplify ihe isi-oidei condiiion in ihe ceiiainiy case.

(y) foi all y:

is decieasing and because boih p c

(y) and py c(y) aie

( pyc(y)) aie negaiively coiielaied. Teiefoie,

(y)) can be posiiive oi negaiive, and so even if, e.g.,

( py c(y)), we cannoi conclude unambiguously ihai

weie concave so ihai E

( py c(y)), ihen we could

, ii would be ihai ii is siiicily convex

> 0). Bui ihis leads io ihe opposiie conclusion: ihai E

(x w)] < 0, since u

() < 0, so ihai V is concave, and show ihai V

See also guie ai end.

x if she doesni diink ihe beei.

High-iisk iypes uiiliiy fiom accepi low iisk coniiaci.

= 2/3 calculaied inExeicise c. You should beai no

foi suie. Teiefoie,

) E[s()] u(E[s()]) E[u(s())] u(s

) u(E[s()]) u(E[s()] E[u(s())]

(0) = 0, and so ihe maiginal cosi of allocaiion eciency

Introduction to the Economics of Uncertainty and Information

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