Financial Decision Making 2

BEE 3034
Spring 2014
Rajiv Sarin
March 28, 2014

Introduction and Course Outline

1. This is a course in Financial Decision Making. To best achieve the
objectives of this course, our approach shall be to rst clearly understand decision making. The setting of decision making will be when
an action results in an uncertain outcome.1 What is rational choice
in this setting. And, is such choice also (typically) observed.
2. Once we have mastered decision theory, we shall apply it to a variety
of nancial frames. We shall cover a number of these.2
3. You are already presumed to be familiar with choice under certainty
(i.e., when there is no risk and each action yields a specic outcome
and that outcome only in every state of the world). You have seen
this in consumer theory and when we discuss preferences and utility.
4. While no single book will be adequate for this course, the closest thing
we have to a text, which will be worth buying, is The Microeconomics
of Risk and Information,by Richard Watt (Palgrave McMillan ISBN
1

That is, for example, you get a dierent outcome ( 1) if it comes up heads and you
get a dierent outcome (- 1) if it come up tails, but you dont know when you make the
decision if it will come up heads or tails. Or, for example, you might get a dierent
outcomes (+ 1, - 1) with dierent probabilities (0.5, 0.5).
2
For details, see the (online) full module specication.

978-0-230-28080-9). I will usually post class material the night before

the lectures and sometimes the morning o.
5. O ce hours for this course will be on Tuesdays and Fridays from
11 to 12. My o ce is at 1.25 Streatham Court. Email contact:
r.sarin@exeter.ac.uk.

The St. Petersburg Paradox

1. Until about the mid-1700s, clever people thought clever people should
(normative economics) and do (positive economics) evaluate lotteries
by the expected value criterion. That is, when choosing among risky
objects, or lotteries, clever people choose the lottery with the highest
expected value.
(a) A (nite) lottery, l, may be represented by the probabilities with
which it gives any of a (nite) number of possible outcomes, which
are all money magnitudes. Hence, a lottery with n possible outcomes, may be represented as
l := (pi ; xi )ni=1
where pi 2 [0; 1] for all i, gives the probability of outcome xi 2 R
and ni=1 pi = 1.
(b) The expected value of lottery l, denoted E (l), is
E (l) =

n
i=1 pi xi :

(c) A more general (than a lottery) risky object is often represented

by a distribution (or, cumulative distribution function). If the set
of outcomes is not nite, then we may describe a risky situation
by the distribution F (or, less generally, a (probability) density
(function) f ), The expected value of F (f ) is
Z
E (F ) = xdF (x)
or,

E (f ) =
2

xf (x) dx

(d) Risky situations or gambles will be interchageably denoted by lotteries l or distribution functions F or density functions f .
(e) Examples. Suppose l = (1=2; $0; 1=2; $2). Then,
E (l) = 1=2

$0 + 1=2

$2 = $1:

If l = (0:999; $1; 0:001; $999). Then,

E (l) = 0:999

$1 + 0:001

$999 = $0:

If F = U (0; 1),3 then

E (F ) = 1=2
2. In the mid-1700s people came across the St. Petersburg paradox. This
led to the serious questioning of the expected value maximization hypothesis.
(a) In the St. Petersburg game a fair coin is tossed and you win 2n
if the rst time a tails appears is on the n-th toss of the coin.
Hence, is n = 10, you win 1024. If this gamble is evaluated
by the expected value criterion you should be willing to pay an
innite amount to play this game (assuming the oerers of this
game are willing to toss the coin innitely often). To see this
note that the expected value of this gamble is
1 1 1 2 1 3
2 + 2 + 2 + :::
2
2
2
= 1 + 1 + 1 + :::
= 1:
The problem was discovered by Swiss Nicolous Bernoulli and his
brother Daniel published an article on it in the St. Petersburg
Academy Proceesings.
(b) Few people are willing to pay above 25 to play this game. And,
if most of us our rational (and EV maximizers) then this gamble
is paradoxical.
3

That is, F is a uniformly distributed (or, has a uniform distribution) between 0 and

1.

(c) One solution (which I nd appealing) is to assume (or, note) that

the amount of money anyone can pay is not innite. Using only
physically realizable nite banks, we know the pot can never exceed some xed amount. If that amount is, say, $1 billion, then
the number of ips can never exceed 30. The expected value, ignoring down-weighting, of 30 ips is only $30 * (1/2) = $15. And
we can, if we like, even include the down-weighting! (Even $1
trillion gives only a max 40 tosses with expected value $20!).4
(d) Daniel Bernoulli suggested that we should use the expected utility
criterion rather than the expected value criterion. That is, if the
options/acts/lotteries give xi 2 R with probability p, then people
should maximize
i pi u (xi ) :
He assumed diminishing marginal utility of money (each additional unit of money gives a smaller increment to utility). In
particular, he suggested that people use log utility. Hence, the
St. Petersburg gamble with log utility gives,
1
n=1

1
2

log (2n ) ! :602 utiles

which would suggest people would be willing to pay upto about

4 for this gamble.
(e) While using log utility resolves this problem it wouldnt if we
n
changed the amount paid to, say, 102 if tails rst appears on the
n-th toss. However, a suitably concave utility function could x
that too. A function f is concave if for all x; y in its domain and
all 2 [0; 1] ; f (x) + (1
) f (y) f ( x + (1
) y) :
(f) From the mid-1700s to the mid-1900s, very clever people thought
clever people evaluate (should) lotteries by the expected utility
criterion.

3. In the mid-1900s von-Neumann and Morgenstern and Savage provided

a behavioral (axiomatic) foundation for the (objective) expected utility
and subjective expected utility criterion (maximization), respectively.
4

The argument in c. supposes payo is 2n

pot and not 1 as above).

(so, each additonal toss adds 1/2 to the

Expected Utility Maximization

1. The von-Neumann and Morgenstern (objective) expected utility theory provided conditions on preferences (choices) over objective lotteries
which imply (and are implied by) expected (Bernoulli) utility maximization. You are expected to be somewhat familiar with this.
2. The four (vNM) conditions on preferences are that they be transitive,
complete, continuous and satisfy the independence axiom.
(a) Utility theory under certainty also assumes the rst three of the
above axioms. The independence axiom is assumed due to the
special nature of the objects amongst which the agent chooses in
choice under objective uncertainty.
(b) Whereas the set of objects in utility theory (choice under certainty) consisted of an nonnegative arbitrary (nonempty, compact
and convex) subset X of Euclidean space Rk+ , the choice set under
considered when an agent faces risk (choice under objective uncertainty) consists of the space of lotteries, L = p 2 Rk+ 1 : pi 0; ki=1 pi = 1 ,
which is often referred to as a (k 1)-dimensional (probability)
simplex, and denoted k 1 , which is a (specic) (non-empty, compact and convex) subset of Rk+ . The lotteries themselves are dened over the nonempty, compact set X . When k = 3 this
set is conveniently repsented by the Machina-Markovitz triangle.
(what does this set look like when k = 2?).
(c) Draw and explain the MM triangle.5 Assume there are three
outcomes 1, 2 and 3 and that the probability of i is pi . Plot
p3 in the vertical axis and p1 in the horizontal axis. Clearly, both
p1 and p3 are greater than or equal to 0 and less that or equal to
1. We know that p2 = 1 p1 p3 . Hence, the unit triangle in
p3 p1 space represents the set of all possible lotteries over the
three outcomes.
i. The set of all 45 degree lines in this triangle represent the set
of all iso-expected value lines. That is, lines in which each
point has the same expected value. As we go from right to
5

See, Machina (1987): Choice under Uncertainty: Problems Solved and Unsolved,
Journal of Economic Perspectives.

left and bottome to top we move across lines with increasing

expected value.
ii. To see (prove?) the claim in (i) note that the equation of an
iso-expected value line is
p1 + 2 (1

p1

p3 ) + 3p3 = k

where k is a constant (the level of expected value along the

line). To see the slope of this line, let us express p3 as a
function of p1 . We get
p3 = (k

2) + p1 :

Note that p1 and p3 are positively related and that a unit

increase in p1 leads to a unit increase in p3 . Hence, the the
MM triangle, the iso-expected value lines (which vary k) have
a (positve) 45 degree slope!
3. The independence axiom states that for all l; l0 ; l00 2 L and
l

l0 , l + (1

) l00

l0 + (1

) l00 :

2 [0; 1] ;

(a) Show that the independence axiom implies that vNM expected
utility indierence curves in L are straight lines?
(b) Can you argue that the independence axiom implies the vNM
expected utility indierence are parallel (in the MM triangle)?
4. The vNM expected utility theorem states that suppose preferences
dened over the space of lotteries k 1 satisfy transitivity, completeness, continuity and the independence axiom. Then there exists a
vNM expected utility function v which represents those preferences
(i.e., l l0 , v (l) v (l0 )) and v (l) = ki=1 pi u (xi ), where u : X ! R
is referred to as the Bernoulli utility function and is unique upto positive a ne transformations. That is, if u (:) represents preferences ,
then u (:) + also represents those preferences, for all a > 0 and
2 R.
5. From the vNM theorem, it follows quite easily that expected utility
indierence curves are parallel straight lines in the MM triangle. To
see this observe that along any expected utility indierence curve
p1 u (x1 ) + (1

p1

p3 ) u (x2 ) + p3 u (x3 ) = k;
6

where k is a constant (equal to the level of expected utility along a

specic EU indierence curve). As all the u (xi ), i = 1; 2; 3, are also
constant we can see (by writing p3 as a function of p1 ) that
p3 =

u (x2 )
k u (x2 )
+
u (x3 ) u (x2 ) u (x3 )

u (x1 )
p1 :
u (x2 )

Hence, EU indierence curves are parallel straight lines with a positve

2 ) u(x1 )
> 1,
slope. If the utility function is concave then the slope u(x
u(x3 ) u(x2 )
as u (2) u (1) > u (3) u (2) because of declining marginal utility
along a concave u. The reverse, of course, is true if u is concave (i.e.,
slope is positive but less than one).
6. We can also plot u against x. u is increasing in x and if it is concave
we know that, e.g., u (2)
0:5u (3) + 0:5u (1), that is, the concave
(risk averse) individual prefers 2 for sure to a 50% chance of 3 and
a 50% chance of 2. This can be plotted back in the MM triangle and
we know that the EU indierence curve passing through the origin is
higher than the that passing through the lottery (0:5; 1; 0:5; 3).
7. The independence axiom plays a central role in the vNM result. As
this result is central to all of decision theory it is worthwhile discussing
it more.
(a) The RHS of the IA equation (after ,)gives us a preference between two compound lotteries. These compound lotteries can be
intrepreted as with probability lambda (or when lambda comes
up) we have a comparison between l and l0 and this follows the
preference from the LHS. And, when probability (1
) (or when
(1
) comes up) we have the degenerate comparison (between
l00 and itself) and the preference it trivially saties (because is
refelexive (because it is transitive and complete)). Deriving the
preference on the LHS (of ,) from the RHS (of ,) follows easily.

(b) Many of the instances in which the independence axiom is violated

occurs when there is a complementarity between (outcomes of)
l00 and one of the other lotteries. This shouldnt be of concern
precisely because l00 occurs when neither l nor l0 occur (i.e., l00
occurs when (1
) comes up).
7

8. For details, see, e.g., Microeconomic Theory, by Mas-Colell, Whinston

and Green (Oxford University Press), Chapter 6.

Risk aversion
1. We know suppose that the outcome set is money (the outcome set is
generally assumed to be more general than money for expected utility
theory). That is, X R.
2. An agent (expected utility maximizer) is risk averse if s/he prefers
the expected value of a lottery to the lottery itself for all lotteries.
Specically,
3. Def: An individual is risk averse/neutral/loving if for all F , E(F )
= = F . We say that individual is strictly risk averse/loving if for
all nondegenerate F , E(F ) = F .
(a) That is, for a risk averse person,
U(

n
i=1 pi xi )

or, more generally,

Z
xdF (x)
U

n
i=1 pi u (xi )

8l

u (x) dF (x)

8F

(b) Suppose, the individual is strictly risk averse. Then, the individual strictly prefers E (F ) to F . Note that the converse need not
be true. That is, if the individual strictly prefers E (F ) to F then
you cannot conclude that the individual is risk averse.
4. The following Proposition provides a way of describing peoples risk
preferences in terms of their Bernoulli utility function u.
5. 8F;

E(F )

(a) Pf: (i)

F () u is concave/a ne/convex.

E(F )

F =) u concave.
E(F )

F () v
() u (E (F ))
() u (E (F ))
8

E(F )

v (F )

u (x) dF (x)

E (u (F ))

This implies u is concave (by Jensens inequality)6 .|

(ii)u concave=) E(F )
F . u concave implies (by Jensens inequality)
u (E (F )) E (u (F ))
You can proceed backward in part (i) of the proof to get the desired
result.||
6. Draw a picture of u on the Y
intuition.

axis and x on the X

axis to give

7. Thus we have two ways of characterizing risk-averse people: (i) E(F )

F , and (ii) u is concave. There are other (equivalent) ways of characterizing risk-averse people. To introduce another way we introduce the
following denition.
8. Def: The certainty equivalent of a lottery F; CE (F ) ; is any outcome
x such that x F . Equivalently,
Z
u (CE (F )) = u (x) dF (x)
or,
CE (u; F ) =

x 2 R : u (x) =

u (x) dF (x)

(a) E.g.: Suppose F = (1; 3; 0:5; 0:5). Suppose you are willing to
pay $2.50 to buy F . Then $2.50 is your certainty equivalent for
the lottery F .
9. Information regarding the existence, and uniqueness, of the certainty
equivalent of a lottery is provided by the following Proposition:
(a) Prop: If X is an interval of Rand u is continuous, then every
lottery F has at least one certainty equivalent. If u is strictly
increasing then the certainty equivalent of a lottery F is unique.
(b) We shall, henceforth, denote the certainty equivalent of a lottery
F for person dened by u by CE (u; F ).
6

What does Jensens inequality say ?

(c) Note that: An individual (represented by u) is risk averse if and

only if CE (u; F ) E (u; F ), for all F .
(d) Prove the statement in c.
10. There is yet another way of characterizing risk averse people. This
is in terms of the risk premiums they are willing to pay to avoid risk.
Hence, let us turn to a denition of risk premium.
11. Def: The risk premium of a lottery F; RP (F ) = E (F )

CE (F ).

(a) E.g.: Let F be as in 8. before. We know E (F ) = 2:0, and we

saw that you were willing to pay $2.50 for the lottery F . That is,
your CE (F ) = 2:5. Then, your RP (u; F ) = 0:50.
12. A person (u) is risk averse if and only if her RP (u; F )

0, for all F .

(a) Note we have several (4) dierent (and equivalent) ways of characterizing risk-aversion: (i) E(F ) F for all F (ii) u is concave,
(iii) CE (u; F ) E (u; F ) for all F , and (iii) RP (u; F ) 0 for all
F.
13. There is yet another way of talking about risk preferences. This is
given by the Arrow-Pratt measure of (absolute) risk aversion. Recall
that Bernoulli utility functions u (over money or the real line) are
increasing. Recall that convavity means that the increase in u is at a
decreasing rate. Hence, we could say an individual is risk averse if the
second derivative of his utility function is negative at all wealth levels,
x). That is, u00 (x)
0 for all x. It turns out this measure of risk
aversion is not invariant to positive a ne transformations of the utility
function. To get that we need to divide u00 by u0 . This gives us a
measure of (absolute) risk aversion. We normalize this measure (so
that it is positive for risk-averse individuals) by taking the negative of
this fraction. Hence,
u00 (x)
RA (x) =
u0 (x)
can also be considered a measure of risk avesion which we refer to as the
Arrow-Pratt measure of absolute risk aversion. An individual with a
(twice dierentiable) Bernoulli utility function is considered risk averse
10

RA (x)
0 for all x. This often turns out to be the easiest way to
gure out if the risk preferences of an individual.
(a) E.g.: Let u (x) = x. Is this u risk averse? Yes. Is is risk loving?
Yes. Hence, it is also risk neutral. We can compute
RA (x) = 0:
(b) E.g.: Let u (x) = ln (x) ; x > 0. Then,
RA (x) =

1
> 0:
x

This individual is risk averse. And her level of absolute risk

aversion decreases as her wealth/money increases.
(c) The general form of an Arrow-Pratt utility function exhibiting
constant absolute risk aversion (seeking) equal to a is
u (x) =
for all x and some

ax

> 0.

(d) The risk aversion of people often thought to be dependent on their

wealth. For this, the concept of relative risk aversion is widely
used. The Arrow-Pratt coe cient of relative risk aversion at x is
given by
u00 (x)
:
RR (x) = x 0
u (x)
Obvoiusly, decreasing absolute risk aversion (which is widely observed) may be consistent with constant relative risk aversion
(which is often assumed to be observed).

Risk of a Distribution/Lottery
1. We have talked about when to call and agent risk averse. This suggest
the obvious way to state when one individual is more (absolutely or
relatively) risk averse than another. However, often it is useful to
know when on distribution (or lottery) is more risky than another.
Informally, we say a distribution F is more risky than another F 0 is F
11

is obtained from F 0 by a (nite sequence of) mean preserving spreads,

where, intuitively, F is obtained from F 0 by a mean presenving spread
if it takes probability mass from the centre of the distribution to its
extremes in such a way that the mean of the distribution is preserved.
For example l = (p; x) = (1=3; 1; 1=3; 2; 1=3; 3) is a mean preseving
spread of l0 = (1; 2) but not a mean preserving spread of l00 = (1; 3).
Additiomal, for example l00 = (1=2; 1; 1=2; 3) is a mean preseving spread
of l (and, hence is considered riskier).
(a) More formally, a distribution F is said to
R be riskier than
R another
0
F if both have the same means (i.e., xdF (x) = xdF 0 (x))
and risk averse agent prefers F to F 0 (i.e.,
Rand if every increasing
R
u (x) dF (x)
u (x) dF 0 (x) for all increasing and concave u).
In this case, F is said to second order stochastically dominate F 0 .
This is the concept of risk of a distribution that is most widely
used in economics.
(b) It is commonly supposed in nance that the variance 2 of a distribution is a good measure of the risk of a distribution. However,
variance is not consistent with second order stochastic dominance.
That is, F and F 0 may have the same mean and F have a higher
variance than F 0 and yet F may not second order stochastically
dominate F 0 .
(c) A distribution F is said to rst order stochastically dominate F 0
if every individual with an increasing Bernoulli utility function
prefers F to F 0 .
(d) Show that the independence axiom implies that vNM expected
utility indierence curves in L are straight lines.

5.1

Example: Variance 6= Risk

This example illustrates the inappropriateness of variance as a measure of

risk. We have 2 lotteries with the same mean. however, the one with
the larger variance is the one preferred by a risk averse expected utility
maximizer!
Suppose
l = (0:8; 1; 0:2; 100)
12

and,
l0 = (0:99; 10; 0:01; 1090) :
Then,
E (l) = E (l0 ) = 20:8
and,
V ar (l) = 1; 568:16 < 11; 547:36 = V ar (l0 ) :
However,
E [log (l)] = 0:92 < 2:35 = E [log (l0 )] :
And, as you all know u (x) = log (x) is risk averse. Its concave! So, the
risk averse person prefers the lottery with the higher variance (and the same
mean) as another.
The moral: except for special cases (e.g., when the variables are fully
described by the rst two moments, as, e.g., in the normal distribution)
there is no reason why the (risk) comparison of two (probability) distributions
needs to be restricted to the rst 2 moments.

Risk Preferences in CC space

1. In the CC diagram, probabilities are xed and monetary prizes are
varable.
2. Suppose that there are 2 possible states of nature 1 and 2 and that their
respective probabilities are p and (1 p). The wealth of the individual
is xi in state i. Plot x1 on the x axis and x2 on the y axis.
(a) In this picture, the 45 degree line represents the certainty line:
the line along which the individual gets the same wealth in each
state of nature. Suppose the individuals certain initial wealth in
x0 = x1 = x2 .
(b) Suppos the individual can buy a lottery l which costs q and payo
o y > q with probability (1 p). That is, the individual gets
the prize in state 2. Hence the lottery l = (p; q; (1 p) ; y p).
Purchasing the lottery gives the individual a nal wealth of (x1 ; x2 ) =
(x0 q; x0 + y q). We can plot this point in the CC diagram.

13

3. Lets consider the expected value E of a given point x in CC space.

Clearly,
E (x) = px2 + (1 p) x1 :
The slope of a line which keeps the expected value constant is
dx2
jdE(x)=0 =
dx1

(1

p)

< 0:

As probabilities are assumed xed in the CC diagram, this is a negatively sloped straight line. Hence, all the iso-expected value lines in
this diagram are given by negatively sloped line. Higher lines represent
higher expected values (why?).
2

4. The variance
2

of an point x in CC space is

(x) = E [x
= p [x2

E (x)]2
E (x)]2 + (1

p) [x1

E (x)]2

Using the formula for E (x) in the above equation, and noting that
(x2 x1 )2 = (x1 x2 )2 , we get
2

(x) = p (1

p) (x1

x2 )2 :

Hence, the line along which variance is kept xed is given by

dx2
jd
dx1

2 (x)=0

2p (1 p) (x1 x2 )
= 1:
2p (1 p) (x1 x2 )

Hence, the iso-variance line in the CC diagram are given by positively

sloped lines with slope 1 (the 45 degree lines). The further you move
away from the certainty line (in both directions), the higher the variance.
5. We can now plot indierence curves in the CC diagram. Recall, that
under the expected utility hypothesis, we have in CC space,
E [u (x)] = pu (x2 ) + (1
Hence,
dx2
jdE(u(x))=0 =
dx1

(1

14

p) u (x1 ) :

p) u0 (x1 )
pu0 (x2 )

M RS (x)

Hence, with positive marginal utility of money (i.e., u0

0) we have
that the indierence curves slope downward. Dierentiating the indifference curve another time, we get
1
0
dx2
00
0
0
00
u
(x
)
u
(x
)
u
(x
)
u
(x
)
2
1
2
1
2
dx1
(1 p) @
d x2
A
j
=
2
2 dE(u(x))=0
0
dx1
p
[u (x2 )]
Substituting x2 = x1 = x0 , we get
0
00
0
0
00
d2 x2
(1 p) @ u (x0 ) u (x0 ) u (x0 ) u (x0 )
j dE(u(x))=0 =
dx21
p
[u0 (x0 )]2
0
1
1 p
00
0
u
(x
)
u
(x
)
1
+
0
0
p
(1 p) @
A
=
2
0
p
[u (x0 )]

(1 p)
p

u00 (x0 )
=
f (p)
u0 (x0 )
= RA (x0 ) f (p)

where f (p) = (1

p) =p2 .

(a) Which suggests that is an individual is more risk averse than another he will be more convex at x0 than the less risk averse individual (as f (p) is the same across individuals). Thus the (strictly)
more risk averse individual accepts fewer gambles than the other
and the ones he accepts are (strictly) within the set of gambles
accepted by the other. Moreover, the set of gambles he accepts
have (strictly) less variance.
(b) Notice we can move backwards along this argument to provide a
foundation for the Arrow-Pratt measure of absolute risk aversion.
6. We know from Jensens inequality that for any x; x0 in CC space and
for any 2 [0; 1], and for any concave/convex u we have
E [u ( x + (1

) x0 )]

E (u (x)) + (1

) E (u (x0 )) :

That is, the expected utility of the lottery lies above (below) the
straight line joining the E (u) of the any two points x; x0 for concave
15

1
A

(convex) individuals respectively. Hence, indierence curves in this

space are negatively sloped and convex with higher indierence curves
lieing above lower ones.
(a) Notice how, concave people dislike variance.
(b) See this in the MM diagram.
7. Show that if f is strictly increasing and concave function then v (x) =
f (u (x)) is more risk averse than u. (Refer to text p.54).
8. Certainty equivalents in the CC diagram. Suppose that the initial endowment of the individual in the CC diagram is x = (x1 ; x2 ) such
that x1 > x2 . Then the point at which the individuals indierence
curve, which passes through x, intersects the certainty line, say x , is
the individuals certainty equivalent for (the lottery which represents)
her initial endowment. Clearly, then
u (x ) = (1

p) u (x1 ) + pu (x2 ) :

Since indierence curves for a risk averse individual are convex, we have
that
E (x) = (1 p) x1 + px2 x :
9. Risk premium in CC space.
= E (x) x gives the risk premiun,
which is zero for risk neutral people and positive (negative) for risk
averse (loving) people (i.e., RP (u; F ) = EV (F ) CE (u; F )). The
more risk averse an individual, the greater the risk premium he is willing
to pay (to avoid a risk/lottery).
(a) Another way of writing (and thinking about) the risk premium of
a lottery F is dened by the following equation
E [u (F )] = u (E (F )
As, E [u (F )]
something (

u [E (F )] for risk averse people, we can subtract

0) from E (F ) so that
u [E (F )

Clearly,

).

] = E [u (F )] :

0 for risk loving people.

16

6.1

Investing in a Safe or Risky Asset

1. Investing in a risky and a safe asset.

2. A invested in the safe asset, invested over a period, returns (1 + s)
the next period. Whereas, the risky asset returns either (1 + r) or
(1 r).with probability (1 p) and p respectively, where r > s. How
should the investor split his investment between the two assets. When,
if ever, will the agent invest in the safe/risky asset?
3. To answer this lets return to CC space.
(a) Draw the certainty line and draw the iso-expected value line going
through (1 + s; 1 + s).7
(b) Notice that we have to see the agents preferences between the
points (1 + s; 1 + s) and (1 + r; 1 r). So, plot these 2 point
in the CC diagram. And, draw a straight line connecting these
points, which shows the returns to dividing the between the
safe and the risky asses, for all possible divisions between the two.
Call this the market opportunities line. This line is less steep
than the iso-expected value line(s).
(c) Notice that the indierence curve which is tangent to (1 + s; 1 + s)
is steeper at that point than the market opportunities line. And,
hence, that IC lies below the market oppportunities line. Clearly,
the indierence curve which is tangent to the market opportunity
line must lie above this one and hence, some of the risky asset
must be purchased.
(d) Where the IC is tangent to the market opportunity line tells us
the share of the we must invest in the safe and in the risky asset.
4. Notice that the individual will always invest in the risky asset (as long
as the slope of the market opportunity line is atter than the isoexpected value line).
7

If the initial wealth is w0 , which has to be allocated between the safe and the risky
asset, then draw the iso-expected value line going through (w0 (1 + s) ; w0 (1 + s)).

17

The Newsvendor Model

1. We want to consider a simple model of demand uncertainty and its
implications for a risk averse producer. A canonical model to study
this is provided by the newsvendor facing demand uncertainty.

7.1

The Model

1. The seller sells quantities of good x, the demand for which is risky. It
is high x1 with probability (1 p) and low x2 with probability p, with
x1 > x2 . The price of the output is xed at q and the cost of the good
is also xed at c. The seller does not produce the good and neither
has any control over its price. The good is perishable, and any unsold
stock is worthless. These assumptions collectively give the model its
name.
2. The problem for the newsvendor is how many newspapers x to order
to maximize expected utility (of prots).

7.2

Solution

1. Notice that if the newsvendor orders x < x2 then there is no uncertainty

and all the newspapers will be sold. We have
E [u (x)] jx<x2 = u (qx

cx) = u (x (q

c)) :

Notice that the marginal utility of x

(q

c) u0 ((q

c) x)

is strictly positive for all x < x2 and so expected utility if strictly

increasing over this interval.
2. If, in contrast, x > x1 we know the newsvendor will have unsold stock
at the end of the day. If x > x1 ,
E [u (x)] jx>x1 = (1

p) u (qx1

cx) + pu (qx2

cx) :

Now, marginal utility of x is

=
< 0

c (1 p) u0 (qx1 cx) cpu0 (qx2

c [(1 p) u0 (qx1 cx) + pu0 (qx2

18

cx)
cx)]

and expected utility is decreasing in this interval.

3. The above analysis tells us the obvious: it is never optimal for the
newsvendor to order x < x2 and nor is it ever optimal for her to order
x > x1 . The signs on the marginal utility in these regions suggests
that it could only be optimal to order in the region x 2 [x2 ; x1 ], or,
x2 x x1 . So, lets move to that region!
4. In the region x 2 [x2 ; x1 ],
E [u (x)] jx2[x2 ;x1 ] = (1

p) u (qx

cx) + pu (qx2

cx)

and the marginal utility of x in this region is

(1

p) (q

c) u0 (qx

cx) + p ( c) u0 (qx2

cx) :

Setting marginal utility to zero, which must hold at the optimum, we

get
(1 p) (q c) u0 (qx
cx ) = pcu0 (qx2 cx )
or,

u0 (x (q c))
=
u0 (qx2 cx )
(1

pc
p) (q

c)

It is convenient to analyze this expression in the regions where (a) pc >

(1 p) (q c), (b) pc = (1 p) (q c) and (c) pc < (1 p) (q c).
Lets go!
(a) pc > (1

p) (q

c). In this region it must be true that

u0 (x (q

c)) > u0 (qx2

cx ) :

If the newsvendor is strictly risk averse, and so u00 < 0, we must

have qx2 cx > x (q c). This implies x < x2 . That is,
our analysis within the interval [x2 ; x1 ] suggests that x 2
= [x2 ; x1 ],
but that x < x2 . We had earlier (in 1.) seen that the expected
utility is not maximized when x < x2 . So, whats going on?
Marginal utility is increasing even at the left boundary of [x2 ; x1 ]
and hence, assuming smoothness of the utlity function, the peak
must lie in the region x < x . But, we know its not in that region.
Hence, the analysis suggests that x2 might be a non-dierentiable
point and the solution is x = x2 .
19

(b) pc = (1

p) (q

c). Hence, we must have

u0 (x (q

c)) = u0 (qx2

cx ) :

Assuming the newsvendor is strictly risk averse, and so u00 < 0,

we must have x = x2 .
(c) pc < (1 p) (q c). Hence, we must have
u0 (x (q

c)) < u0 (qx2

cx ) :

u00 < 0 now implies qx2 cx < x (q c). This implies x > x2 .
(d) Lets simplify the inequality determining whether x = x2 or x >
x2 . That is, simplify
pc

(1

p) (q

c)

in which case the optimal solution is x = x2 .

can be written as
c (1 p) q
or,

This inequality

:
q
Hence, if the probability of the low demand is high enough, and
high enough is only determined by the parameters of the model
(which are outside of the control of the newsvendor) then a strictly
averse newsvendor chooses to only get x2 (i.e., she insures herself
against risk). This result does not depend on how risk averse
the newsvendor is. Only when x 2 (x2 ; x1 ] does the degree of
risk aversion play a role in how much risk the newsvendor exposes
herself to. For exmple, a risk-neutral newsvendor would order
x1 when p < (q c) =q but would order less than that if she were
strictly risk-averse.
p

Production under Demand Uncertainty

1. In the newsvendor model we had demand risk of a very special kind.
The marginal cost and the price of the output was xed exogenously
and given to the newsvendor. Here we give up both these simplifying
assumptions. Now we study a (risk averse) producer who experiences
demand uncertainty resulting in her facing an uncertain price.
20

8.1

The Model

1. The producer produces quantities good x. The technology of production is described by a cost function c (x) which in increasing and convex
with c (0) = 0. The price at which the producer can sell the good is
given by the demand function d (x), with d0 (x)
0.8 In particular,
she experiences shock "1 with probability (1 p) and shock "2 with
probability p, where "1 > 0 > "2 with E (") = (1 p) "1 + p"2 = 0.
The producer has a utility function u which is strictly increasing and
concave over prots and wants to maximize the expected utility of prot
E [u ( (x))] = E [u ((d (x) + ~") x c (x))]
= (1 p) u ( 1 (x)) + pu ( 2 (x))
where,
1

(x) = (d (x) + "1 ) x

c (x)

(x) = (d (x) + "2 ) x

c (x)

and,
2. If there was no uncertainty, the producer would maximize
u [ (x)] = u [d (x) x

c (x)] :

If, additionally, the producer was risk neutral, as is typically assumed,

the producer would simply maximize
(x) = d (x) x

c (x) :

You have solved this problem in the past when you studied producer
theory (in microeconomics).
3. Returning to the problem at hand, the FOC for maximization are
dE [u ( (x))]
= (1 p) u0 ( 1 (x )) 01 (x ) + pu0 ( 2 (x ))
dx
where
0
0
c0 (x) ;
i (x) = d (x) x + d (x) + "i

0
2

(x ) = 0;

for i = 1; 2.
8

In comparison with the newsvewndor problem both the demand function and the cost
function now are more general. It might, thereforee, make sense to try to generalize the
newsvendor model step by step, relaxing just one of its assumptions in each step. Try it.

21

(a) The SOCs require that

n
o
d2 E [u ( (x))]
2
00
0
0
00
=
(1
p)
u
(
(x
))
[
(x
)]
+
u
(
(x
))
(x
)
1
1
1
1
dx2
n
o
2
00
0
0
00
+p u ( 2 (x )) [ 2 (x )] + u ( 2 (x )) 2 (x )

is negative. This in turn depends on the sign of

00
i

(x) = d00 (x) x + 2d0 (x)

c00 (x) :

We know, by assumption, that d0 (x) 0 and c00 (x) 0, hence,

to obtain the required result that the sign of the above second
derivative is negative, we need to assume that d00 (x) is not too
positive.
4. Lets do the above analysis with specic functions that satisfy the assumptions of the model and see what intuition we gather from this
more specialized analysis.
(a) Suppose the cost function c (x) = x, where > 0 is the marginal
cost and there are no xed costs. We have c (0) = 0, c0 > 0 and
c00 = 0 and so the assumptions of the model on the cost function
are satised. Next, suppose the demand function d (x) =
x,
where > 0 and > 0. Hence, d0 < 0 as required by the model.
(b) If you want to simplify this further you can assume probability of
"1 = 1; "2 = 1 and p = 1=2. Hence, shocks have an expected
value of zero. Additionally, you may assume u (x) = e x .
(c) Show that with the additional assumptions the amount the riskaverse producer producer is less that what a risk neutral (u (x) = x)
producer produces.

A Financial Market

Consider a 2 rm j economy, 2 state i economy.

1. A rm j is made up of N j shares, with xed price v j . Hence, the value
of rm j is v j N j , j = 1; 2.
22

2. Owning a share
j
. Assume j

of rm j gives the owner a right to

0. Prots in state i of rm j are

of her prots

j
i

3. Let probability of state 2 be p and probability of state 1 be (1

j

4. An individual who owns

p).

of rm j (j = 1; 2) has wealth in state i of

1 1
i

wi =

2 2
i

i = 1; 2

5. Assume that the individuals initial shares of the 2 rms are given by
j
0 , j = 1; 2. Hence, an individuals budget constraint is
1 1

2 2

v N1 +

1 1 1
0v N

v N2

2 2 2
0v N

or,
1

1
0

v1N 1 +

2
0

v2N 2

0:

6. The optimal portfolio of an investor involves maximizing w.r.t.

E [u (w~ ( ))]
s.t. the budget constraint in 6.
j
0.

and the nonnegativity restrictions

7. Set up the Lagrangean

L ( ; ) = pu

1 1
2

2 2
2

+(1

1 1
1

p) u

2 2
1

and obtain the FOC

p 12 u0
p 22 u0

1 1
2
1 1
2

+
+

2 2
2
2 2
2

+ (1

p)

+ (1

p)

1 1
1
1 1
1

1 0
1u
2 0
1u

+
+

2 2
1
2 2
1

v1N 1 = 0
v2N 2 = 0

and the CS conditions

1

1
0

v1N 1 +

2
0

8. Notice that the FOC conditions indicate that

p 12 u0 1 12 + 2 22 + (1 p) 11 u0
=
v1N 1
1 1
2 2
2 0
p 2u
p) 21 u0
2+
2 + (1
=
v2N 2
Hence, the CS conditions become
1

1
0

v1N 1 +
23

2
0

v 2 N 2 = 0:
1 1
1

2 2
1

1 1
1

2 2
1

v2N 2 = 0

> 0:

1
0

v1N 1 +

2
0

v2N

9. Re-writing the FOC, we get

p 12 u0
p 22 u0

1 1
2
1 1
2

+
+

2 2
2
2 2
2

1
0

+ (1
+ (1

p)
p)

1 1
1
1 1
1

1 0
1u
2 0
1u

+
+

2 2
1
2 2
1

v1N 1
:
v2N 2

Coupled with
v1N 1 +

2
0

v2N 2 = 0

we get the solution to the portfolio choice problem.

10

Insurance

1. The insurance industry provides one of the main ways in which risk is
shared between economic agents. A deeper analysis also reveals that
the information available to agents, at the times they contract, can
have a major impact on insurance. This gives rise to the phenomena
of moral hazard and adverse selection that are important aspects of
this industry.
2. Chapter 4(.2) of Watt is an essential reference. Chapter 9 in The Economics of Uncertainty and Information by J.J. Laont (1989, MIT
Press) will also be important as is Chapter 5 in Watt.

10.1

The Model

1. The basic setting is that of a risk averse individual facing (wealth)

uncertainty having the opportunity of being able to insure some or all
of the risk he faces with a rm which might be part of a perfectly
competitive or monopolist industry. The rm is often supposed to
be risk neutral though she might also be risk averse. What kind of
market interaction (transaction) takes place between the two is the
focus of attention. In particular, will the individual insure part of all
of the risk she faces and what price would she have to pay for it.
2. The individual (an EU maximizer) has strictly increasing Bernoullli
utility function u and initial wealth w0 . She, additionally, faces a lottery l = ((1 p) ; 0; p; L). This can be interpreted as the individual
facing a loss of L > 0 with probability p. Note its expected value of
24

the lottery is pL and the expected wealth of the individual is w0

Hence, she has utility
v (w0 ; l) = (1

p) u (w0 ) + pu (w0

pL.

L) .

(a) Supposing that in state 1 she doesnt make a loss and faces the
loss in state 2, we can plot the initial position of the individual in
the CC diagram. Call it A.
(b) Additionally, you can draw the is-expected value line that goes
through A and the indierence curve going through A.9 Draw
also the certainty line. Observe the set of allocations which lie
above her indierence curve and beneath the is-expected value
line (call this region B (A) for the attainable better than A region). And, also, the points where her indierence curve intersects the certainty line (call it B) and where the is-expected value
line intersects the certainty line (call it C).10
3. Suppose, there exists a risk neutral rm (agent) who is willing to oer
the individual (Jill) insurance. Call the agent/rm Jack. If Jack
operates in a competitive industry, then he will not be making any
expected prot from the insurance he oers.
(a) Jack would make no expected prots if he oered any contract of
the iso-expected value line passing through A. (Why)? And, if
Jill was oered all such contracts she would choose the contract
on the iso-expected value line which intersects the certainty line.11
4. If Jack was a monopolist then Jack could oer the contract C to Jill
and Jill would accept it. Jack, then, would make expected prots equal
to the risk premium Jill is willing to pay to insure the risk she faces.
To see this, observe that C represents the certainty equivalent of the A
for Jill. And, B has the expected value of A. Hence, = C B.
9

Whats the equation of the iso-expected value line going through A? Note that this
is the w0 pL iso-expected value line. (why)?
10
What are the (x and y) coordinates of A and C?
11
Solve this problem through mathematical techniques.

25

5. More generally, suppose Jack oers to provide one unit ( ) of insurance

for q. Hence, he provides L units of insurance to Jill for qL. Then,
if Jill would choose the amount of coverage G she would she would
max
G

(1

p) u (w0

qG) + pu (w0

L+G

qG) :

The FOC of this are

q (1

p) u0 (w0

q) u0 (w0

qG) + p (1

L+G

qG)

or,

p (1 q)
u0 (w0 qG )
= 0
:
q (1 p)
u (w0 L + G
qG )
Suppose q = p. Then, the RHS of the above equation would have to
be 1. If u is assumed to be strictly concave,12 this requires
w0

qG = w0

L+G

qG ;

which requires that

G = L;
or, that Jill buys full insurance. A per unit insurance charge of q = p
is termed actuarially fair.13
(a) You can easily check that when q < p, then Jill would demand
more than full insurance. That is, G > L. As this is often ruled
out by insurance companies, this case is not too interesting.
(b) What happens when q > p. Then, G < L. Represent this oer
of insurance diagrammatically and conrm the solution.
(c) What if Jack oers insurance cover of G at the cost of qG + k,
where k can be interpreted as the xed cost for Jill to enter the
insurance market (and that Jack might charge to cover his xed
costs)? We shall analyze this case.
6. If Jack oers insurance cover of G at the cost of qG + k, where k can
be interpreted as the xed cost for Jill then she
max (1
G

12
13

p) u (w0

(qG + k)) + pu (w0

L+G

(qG + k))

You check that the SOC are satised for a maximum of a strictly concave u.
It is the per unit cost of insurance which gives Jack zero expected prot.

26

Her FOC are,

(1

p) qu0 (w0

(qG + k)) = p (1

q) p (1

q) u0 (w0

L+G

(qG + k)) ;

or,

(1 p) q
u0 (w0 L + G
(qG + k))
=
:
0
p (1 q)
u (w0 (qG + k))
(You can check that the SOC are satised due to the assumption of
strict concavity of u).
(a) Again, if p = q, the the LHS of the above equality is equal to 1
and so,
u0 (w0

L+G

(qG + k)) = u0 (w0

(qG + k)) :

So, for a strictly concave u we have

w0

L+G

(qG + k) = w0

(qG + k)

or,
G = L:
But, now we additionally require
u (w0

(pL + k))

(1

p) u (w0 ) + pu (w0

L) :

That is, k must be such that (i.e., small enough) so that the
above inequality is satised. Note that, we have seen the degree
of concavity of the individual determines the risk premium and,
hence, the maximum value of k. Speccally, we know that the
risk premium satises
(1

p) u (w0 ) + pu (w0

L) = u (w0

Hence, the solution is G = L when k

k> .

pL

):

and G = 0 when

(b) If q > p, we have that we have

u0 (w0

L+G

(qG + k)) > u0 (w0

(qG + k)) :

Then,
w0

L+G

(qG + k) < w0

because of concavity and, hence,

G < L:
27

(qG + k)

(c) Picture the above argument in the CC diagram.

7. It is interesting to see the eect of an exogenous increase in (risk-free)
wealth on optimal insurance. Here we focus on the case where q > p.
Not surprisingly, the result depends upon whether the Arrow-Pratt
measure RA (x) is a decreasing function of x or not. It is commonly
assumed that risk aversion (and RA (x)) decreases as wealth (x) increases. In this is the case, then optimal insurance would decrease as
wealth increases. (for details see p. 84-87 in Watt).

10.2

Adverse Selection

1. Suppose there are 2 types of agents with low risk pl and high risk ph
of a loss L, with pl < ph . The agents know their probabilities by the
insurance company doesnt. Suppose the insurance company oers
insurance
2. Then the high risk agents maximizes
max (1
G

ph ) u (w0

G) + ph u (w0

L+G

qG)

and, has FOC

u0 (w0
u0

L + Gh qGh )
(1 ph ) q
=
:
(w0 Gh )
ph (1 q)

Analogously, the low risk agents FOC are

u0 (w0 L + Gl qGl )
(1 pl ) q
=
:
0
u (w0 Gl )
pl (1 q)
(a) Since,
1

ph
ph

<

pl
pl

we have Gh > Gl
(b) Diagrammatically, in the CC space, starting from the initial allocation, the low risk agent has a steeper iso-expected value line of
slope (1 pl ) =pl than the high risk agent.

28

(c) If q 2 (pl ; ph ) then the low risk agent underinsures (as the rate if
high for him) and the high risk person overinsures.
(d) If the price is made suitable for the high risk types, then the low
risk types might take no insurance at all (or might even take out
negative insurance). This, then, is analogous to Akerlofs lemons
market in the realm of insurance.

10.3

Moral Hazard

1. Suppose Jill can change her probability of having an accident by engaging in some (costly) eort x which is not obseved by Jack. Then,
the function p (x) describes the probability of losing L. Then, if the
pricing of the insurance polify takes this into account, Jill would solve,
max (1
x;G

p (x)) u (w0

p (x) G)+p (x) u (w0

x+G

p (x) G) :

The FOC are

u (2)

u (1) p0 (x )

p (x ) (1 + p0 (x ) G ) u0 (2) (1 p (x )) (1 + p0 (x ) G ) u0 (1) = 0
p (x ) (1 p (x )) u0 (2) (1 p (x )) p (x ) u0 (1) = 0

where u (1) and u0 (1) refer to the no-loss state, and u (2) and u0 (2)
refer to the loss state. The last condition implies u0 (1) = u0 (2) and so
insurance is complete. The rst FOC then simplies to 1+p0 (x ) L = 0.
2. But, as the insurance company cannot observe x it might set price q
that is independent of x. Then, Jill would maximize
max (1
x;G

p (x)) u (w0

qG) + p (x) u (w0

x+G

qG) ;

for which the FOC are

p0 (x ) (u (2)

u (1))

p (x ) u0 (1)

(1

p (x )) u0 (2)

0
= 0 if x > 0

and,
p (x ) (1

q) u0 (2)

29

(1

p (x )) qu0 (1) = 0

(a) The zero prot condition implies that q = p (x ), where x is the

amount of self-protection in equilibrium. The last condition implies that u0 (2) = u0 (1) that is complete insurance. The condition
before can then be re-written as
u0 (1) < 0
= 0 if x > 0:
But, since, u0 (1) > 0 we must have x = 0! Hence, in perfectly
competitive equilibrium there is no self protection and the price
of insurance is compatible with it, p (0). Agents do not take into
account the positive (pecuniary) externality created by positive
self-protection (which allows a lower rate of insurance to be oered
to all, is all engage in it)

11

Sharing Risks

1. One of the major purposes of nancial markets is to share risk among

individuals. We have seen it in the context of insurance. Now, we
shall move to develop a more general understanding.
2. Let the initial endowment of the individual i be wi = (w1i ; w2i ), i.e, her
wealth in each of the 2 states. Assume w2i < w1i for i = 1; 2: Hence,
totoal aggregate wealth in state 2, W2 = w21 + w22 < w11 + w12 = W1 ,
the aggregate wealth in state 2. In such a sitution, we say there is
aggregate risk.
3. Now, lets draw the Edgeworth box, for a world (2 person, 2 state),
drawing state 1 on the horizontal axis and state 2 on the vertical.
Wealth of individual 1 in either is measured from the bottom-left and
that of the second individual is measured from the top-left. Notice the
box is longer than it is tall.
4. Draw the certainty line for each individual in the Edgeworth box (under
risk). Label it C1 for individual 1 and C2 for individual 2. Draw the
initial endowment between the certainty lines (why?) and draw the
indierence curves of the two individuals going through these points.

30

5. Draw the contract curve in the Edgeworth box. Note that if there
is aggregate risk and the individuals are strictly risk averse then the
contract curve lies between the two certainty lines. Why?14
(a) Exceptions 1: If one agent is risk neutral then the contract curve
will coincide with the certainty line of the other individual.
(b) Exceptions 2: If there is no aggregate uncertainty. Then the
certainty lines of the two individuals coincide and the contract
curve coincides with it.
6. The marginal rate of subsitution of individual i is
(1

p) u0i (w1i )
:
pu0i (w2i )

Along the contract curve,

(1

p) u01 (w11 )
(1 p) u02 (w12 )
=
pu01 (w21 )
pu02 (w22 )

and wj1 + wj2 = Wj , j = 1; 2. As the probabilities cancel we get, along

the contract curve
u01 (w11 )
u02 (w12 )
=
:
u01 (w21 )
u02 (w22 )
The probabilities disappear as they are the same across individuals (we
are in a world of risk with given objective probabilities and not in a
world of uncertainty).
7. More on the slope of the contract curve. Focus on individual 1. Let
wi1 = wi and so wi2 = Wi wi , for i = 1; 2. The equation of the
contract curve can now be written as
u01 (w1 ) u02 (W2

w2 ) = u01 (w2 ) u02 (W1

w1 ) :

Taking logarithms we get

ln u01 (w1 ) + ln u02 (W2

w2 ) = ln u01 (w2 ) + ln u02 (W1

14

w1 ) :

We know the slope of the IC when it passes through the corresponding certainty line
is (1 p) =p, where p is the probability of state 2. Hence, the IC cannot have this slope
when it passes through the certainty line of the other individual. Also, ...

31

Dene
h (w1 ; w2 ) := ln u01 (w1 ) + ln u02 (W2

w2 ) ln u01 (w2 ) ln u02 (W1

w1 ) :

Hence, the contract curve is dened by the function

h (w1 ; w2 ) = 0
where w2 = c (w1 ).
8. To get the slope of the contract curve, we can use th implicit function
theorem to get
dw2
dh ( ) =dw1
jdh( )=0 =
dw1
dh ( ) =dw2
where dh ( ) =dw2 6= 0. Notice
u00 (w)
@ ln (u0 (w))
= 0
=
@w
u (w)

RA (w)

Now,
@h ( )
=
@w1

1
RA
(w1 )

2
RA
(W1

w1 ) < 0

and,
@h ( )
2
1
= RA
(W2 w2 ) + RA
(w2 ) > 0:
@w2
Hence, the slope of the contract curve at any interior point is given by
2
@w2
R1 (w1 ) + RA
(W1 w1 )
jdh( )=0 = A
:
2
1
@w1
RA (W2 w2 ) + RA
(w2 )

Hence,
(a) The contract curve has strictly positive slope in the interior.
(b) Since the contract curve lies between the two certainty points,
w1 > w2 and W1 w1 > W2 w2 , the contract curve has slope 1
if both individuals have constant absolute risk aversion; has slope
less than 1 if both individuals have decreasing absolute risk aversion and slope greater than 2 if both individuals have increasing
absolute risk aversion.
32

11.1

Contracts with Constant Proportional Risk Sharing

1. Many contracts oer constant proportional risk sharing. Specically,

any contract that shares prots in a, say, 50-50 or 20-80 or 10-90 or
similar way shares the risks (of uctuating or random prots) in a constant proportional way. Are such contracts good, sensible, or Pareto
e cient, in any way which may account for their popularity?
2. We may consider Wi , total wealth in state i as a random variable, which
we may think of as prots. A general rule for sharing prots15 then
takes the form
wi = ki (Wi )
and, the constant proportional rule is given by
wi = W i

i = 1; 2:

Hence, in the constant proportional case

=

w2
w1
=
W1
W2

and,
w2 = W 2 =

w1
W1

W2 =

W2
W1

w1 :

Clearly, this is a point on the diagonal in the Edgeworth (risk) box.

When does the contract curve intersect or lie on this diagonal?
3. Lets consider the case of CRRA utility. Relative risk aversion RR (x) :=
(u00 (x) =u0 (x)) x. CRRA utility functions have the form
x1 r
u (x) =
:
1 r
The marginal utility of wealth is u0 = 1=xr , which goes to 1 as x ! 0.
And, r is the constant coe cient of relative risk aversion.
15

This is further justied by the mutuality principle, which states that in a Pareto
e cient risk allocation the nal wealth of each individual in each state will only depend
on the aggregate wealth in that state.

33

4. We know h (w1 ; w2 ) = 0 gives the equation of the contract curve. Let

ri be the coe cient of RRA for agent i. Then, we may write h using
the current utility function as
ln

1
w1

r1

+ln

r2

1
W2

1
w2

= ln

w2

r1

r2

+ln

W1

w1

or,
r1 [ln (w1 )

ln (w2 )] = r2 [ln (W1

w1 )

ln (W2

w2 )] :

Hence,
r1 > = = = < r2 () ln (w1 ) ln (w2 ) < = = = > ln (W1

w1 ) ln (W2

or,
r1 > = = = < r2 ()

W1
w1
<===>
w2
W2

w1
w2

r1 > = = = < r2 ()

w2
W2
>===<
w1
W1

w2
:
w1

or,

5. Any point along the diagonal of the Edgeworth box is dened by w2 =

w1 . Hence, along the diagonal
w2
w1
=
= :
w1
w1
And,
W2
W1

w2
=
w1

(W1 w1 )
= :
W1 w1

Hence, if (w1 ; w2 ) is along the diagonal we get

w2
=
w1

W2
W1

w2
:
w1

6. Hence, if r1 = r2 the contract curve coincides with the diagonal line

and constant proportional risk sharing contracts are Pareto e cient.

34

w2 )

12
12.1

Adverse Selection
The Market for Lemons

1. Weve seen the issue of adverse selection before, in the case of insurance
markets. Now, were going to study it in the more general framework
of asymmetric information. But, lets remind ourself with Akerlofs
famous Lemons market example.
(a) Suppose there is (potential) buyer and seller of a used car. The
used car may be of one of two quality types, good v1 and bad
v2 , with v1 > v2 . The seller knows the value of the car, but
(both seller and) the buyer know that with probability p it is
good and (1 p) it is bad. All of the above is common or mutual
knowledge.
(b) Given the above, we know the buyer values the car at pv1 +
(1 p) v2 . The question is what price will prevail in this market. Clearly, the buyer would buy the car if the price is below
pv1 +(1 p) v2 . However, at that price only the bad car would be
sold. If the buyer realizes this, then she will not buy. The good
car would onlly be sold if a price of v1 we oered. But, then also
the bad car seller would claim his car was good and, as the buyer
cannot discriminate between the cars, he should not buy the car.
(c) If v2 were the price of the car, then the bad car would be sold but
not the good and we would have the buyer interested. Hence,
the bad cars, in the second hand used car market, tend to drive
out the good cars. Hence, the used car market is really a market
of/for lemons (i.e., bad cars).
(d) In the above model/story the seller of good second hand cars suffers. What can she do to rectify this problem. Clearly, she
could guarantee the cars. But, if there is no enforcement mechanism, and the guarantees were free then sellers of both type of
cars would provide a guarantee. What do you observe in second
hand markets as methods to sell good cars (other second hand
items) when the seller has better information on the product than
the potential buyer)?

35

12.2

(job market) Signalling

1. One famous mechnasim, that has come to be called signalling (in the
economics literature), was suggested by Spence. The classical market
it is set in is the market for sellers and buyers of people (workers):
employers and employees. This is the market for job market signalling.
(a) Suppose there are two kinds of employees, good of value v1 to
the employers and bad of value v2 to the employers. Workers
know their type, but employers only know the probability that
the worker is good is p and that he is bad is (1 p). (And, all
the above is common knowledge).
(b) As in the market for lemons, employers have di culty hiring the
(only) good workers. Suppose there exists a mechanism perfectly
correlated with the types of the workers which the employers can
employ for the workers to signal their type. Lets call this mechanism education. Good workers have a cost of c1 of getting a unit
of education and bad workers have a cost of c2 , with c1 < c2 .
(c) The employer pays a wage w = v2 for anyone with level of education e < e , and he pays w = v1 for this with education of e e .
The employer calculates e such that only good workers get education e e and the bad workers get no education. Given workers
are risk neutral, the employers needs to calculate e such that
v2
v2
or,

v1

v1
v1

v2
c2

c1 e
c2 e
v1

v2
c1

(d) Note, that good workers are handicapped in that they have to pay
for the educational signal, which does not raise their productivity
but just signals to the employers that educational recipients are
good workers. Hence, education is socially wasteful (in the Spence
model), so the socially optimal level should be to set it at the
lowest possible. Which is
e =
36

v1

v2
c2

(e) Notice how education is separating good from bad type of workers
is similar/related to how good cars might get separated from bad
cars, by being approved used or guaranteed by the seller at
some cost to the seller.

12.3

The Principal Agent Model

1. Now lets introduce risk in the above setting and proceed to the principalagent setting under risk. Lets rst x the basic set-up in this case.
(a) The Principal may be taken to be the employer (rm) and the
agent the (potential) employee. There are two dierent types of
agents type 1 and type 2, with types only known to the agents.
There is a commonly known probability that an agent is good
and (1
) that he is bad.
(b) There are two states of the world, 1 and 2, with 1 being better for
the principal for both types of agents. Specically, suppose that
in state i the principal gets a monetary payment xi with x1 > x2 .
If the principal contracts with agent i then the probability of state
2 is pi with p1 < p2 . Hence, agent 1 is better in the sense of have
a higher probability of the better state.
(c) A contract by the principal is a wage vector w = (w1 ; w2 ) that
the agent will receive in each of the two states. The payo to the
principal in the two states is then w = (x1 w1 ; x2 w2 ). Thus
the contract remunerates the agent and shares the risk.
(d) The principal may oer a menu of contracts but has to oer the
same contracts to all the agents (because she cannot discriminate
between the two agents). In equilibrium, however, no more
than two contracts need to be oered by the principal as each of
the two types of agents will choose a specic contract. Our job
is to nd the optimal contacts w1 and w2 that will (should) be
oered.
(e) Notice that it could be the case that in equilibrium all agents,
regardless of their type, choose the same contract. Then, in that
pooling equilibrium, the principal cannot distinguish between the
agents. However, it may be the case that the dierent types of
agents choose dierent contracts. In such a separating equilibrium,
37

the principal does manage to distinguish between the agents (as

the agents self-sort themselves). In principal-agent settings, these
are the two types of equilibria that we focus upon.
2. Assume that the principal is risk neutral (concerned only with expected
prots) and the agent is strictly risk averse agent with an increasing
utility function (so, u0 > 0; u00 < 0). If the principal contracts with a
type i agent, her prots would be
Ei (~
x

w)
~ = (1 pi ) (x1
= Ei (~
xi ) (1

w1 ) + pi (x2 w2 )
pi ) w1 pi w2

and the expected utility of type i agent is

Ei [u (w)]
~ = (1

pi ) u (w1 ) + pi u (w2 )

i = 1; 2:

Notice we are assuming the agents have the same Bernoulli utility function u.
(a) If we plot the indierence curves of the agents in the CC diagram
(in w1 w2 space), they would be decreasing curves which are
convex to the origin whose slope are w for agent i would be
(1

M RSi (w) =

pi ) u (w1 )
pi u (w2 )

i = 1; 2:

Hence, when the indierence curves intersect the certainty line,

their slope would be
M RSi (w) jw1 =w2 =

(1

pi )
pi

i = 1; 2:

Hence, agent 1s indierence curves are steeper. Clearly, indierence curves to the north-east are the more preferred ones for both
agents.
(b) The indierence curves for the principal are downward sloping
straight lines with slope depending on which agent the principal
is contracting with. With agent i, they have slope
(1

pi )
pi

i = 1; 2

and, hence, are steeper when contracting with agent 1. Clearly,

the principal prefers indierence curves to the south west.
38

3. Assume the reservation utility of the principal is 0 and the reservation

utility of agent i, ui , is such that u1 > u2 . That is, the more able agent
1 has a higher level of reservation utility. Thus, along the certainty
line, the reservation utility indierence curve of the more able agent 1
is higher than that of agent 2. Hence, these two indierence curves
intersect one another at a point w0 with w1 > w2 . Plot all of the
above.
4. Now, let us think of the constraints that a contract w must satisfy.
Firstly, because the contract is voluntary, it must satisfy the participation constraints for each person. For the two types of agent and the
principal, they respectively are
(1 pi ) u (w1 ) + pi u (w2 )
Ei (~
x) (1 pi ) w1 pi w2

ui
0:

i = 1; 2

Secondly, if the principal does oer 2 contracts, w1 and w2 , one intended

for each agent, it must be the case that
Ei u w~ i

Ei u w~ j

i; j = 1; 2:

That is, each agent i must prefer the contract intended for him to the
contract intended for the other person. This condition has to hold as
the principal must oer both contracts all agents, because she cannot
distinguish among the agents.
5. Before we solve the above model, with involves asymmetric information, it is useful to provide a benchmark outcome that would result
is information was symmetric and perfect, in which case the principal
would know the type of agent (which currently only the agent knows
and the principal doesnt).
(a) In the situation of symmetric and perfect information, the principal could (and would) deal with the two agents separately. Here
the outcome would resemble what we have seen in our analysis
of the insurance market. As she is risk neutral and the agents
are risk averse, the solution (optimal contract) would lie on the
certainty line.

39

(b) If the market were perfectly competitive, then it would be at the

point where the principals indierence curve through w0 (the initial endowment) passes the certainty line (and so the agent keeps
the expected value of his initial endowment). If the principal were
a monopolist, then the agent would lie at the certainty equivalent
of her initial endowment.
(c) In each case, the outcome (wealth) that is received by the more
able type 1 agent is greater than that received by the type 2 agent.
6. The analysis under perfect and symmetric information clearly suggests
that the solution to our asymmetric information problem depends upon
on the market in which the principal operates. That is, whether it is
perfectly compatitive or not. So, lets begin the analysis of the problem
by assuming perfect competition.
(a) We can set up the problem as a Lagrangean contrained optimization problem. Then, we would maximize the utility functions of
eacvh type of agent subject to the constaints that the principal
makes zero prot16 and that the 2 participation constraints and
the 2 incentive contraints are satised. This would give us 4 rst
order conditions and 5 contraints and we would have to solve a
system of 9 simultaneous equations in 9 variables (the 4 objective
varianles and the 5 lagrangean multipliers). This is a large mathematical problem (esp.without computers/calculators). We shall
instead solve it graphically to get the essential insights.
(b) Firstly, observe that the optimal contract cannot have w1 = w2 .
That is, there cannot be a pooling equilibrium. Lets call w1 =
w2 = w and dene q = p1 + (1
) p2 . Then, the zero prot
condition of the principal can be re-written
w2 =
16

E1 x~ + (1
q

) E2 x~

1
q

The principals constraint would be

E1 x
~

w
~ 1 + (1

) E2 x
~

40

w
~ 2 = 0:

w1 :

This line sits, in slope, between the other 2 zero prot lines,
x w)
~ = 0 and
which have slopes of 1 p1p1 and 1 p2p2 , for E1 (~
E2 (~
x w)
~ = 0 respectively. Observe what whether the pooling
point in to the left or to the right of the certainty line, we cannot
have the slopes of both the dienrent types of agentsindierence
curves tangent to the E (~
x w)
~ = 0 line at the same point (why:
recall the slopes of the two indierence curves as they cut the certainty line and compare them to the slope of the E (~
x w)
~ =0
line). Hence, we cannot have a pooling equilibrium. (If the
principal allowed rms to choose there they would locate on the
E (~
x w)
~ = 0 line then type 2 agents would locate to the left of
the certainty line and type 1 agents to the right and this would
cause the principal to lose money. To see this look at the prot
lines of the principal for these two agents through their choice on
the E (~
x w)
~ = 0 line and compare it to, say, the point at which
it crosses the certainty line).
(c) Hence, the principal must design separate contracts for these two
types of agents. Hence, the contract designed for type 1 agents
should pass through the E1 (~
x w)
~ = 0 line and the contract
designed for type 2 agents should pass through the E2 (~
x w)
~ =0
line. If one wasnt located on the respective line the other must
also not lie of the line. Hence, to prove the claim we need only
show that one such type of agent must lie on their respective
line. Suppose it wasnt. Then, one contract would give positive
prots and the other negative prots. And, hence, every principal
would only oer the contract yielding positive prots. This would
destroy the assumption of perfect competition in the market.
(d) Now choose some contract for agent 2 along the E2 (~
x w)
~ =0
2
line. Call this point w . Assume it is to the left of w0 . See
where the indierence curve of agent 2 which passes through w2 ,
E2 [u (w~ 2 )], intersects the E1 (~
x w)
~ = 0 line and call that point
1
2
w (w ). Now, by the incentive compatability constraint, the
contract oered to agent 1, w1 , cannot lie on an indierence curve
above E2 [u (w~ 2 )] and it must lie of E1 (~
x w)
~ = 0. The point
1
that maximizes E1 [u (w~ )] subject to that it must not lie above
E2 [u (w~ 2 )] and intersect the E1 (~
x w)
~ = 0 line is clearly the point
1
2
we have found, w (w ). Hence, we now only need to ensure that
41

the w2 we have chosen was chosen optimally. Now the contract

which maximizes their utility subject to being on the E2 (~
x w)
~ =
0 line is clearly reached along the certainty line.
(e) We have found the solution. We have optimizes the choice of type
2 agents given the principals budget constraint. And, we have
chosen the optimal point for type 1 agents, given the choice of type
2 agents. And, we have ensured that the principal makes zero
prots. We should now be able to solve such problems analytically
(and, we have learnt to do so without ever having written out the
full Lagrangean optimization problem!).
7. For a monopoly principal, in the equilibrium contract, we must have (i)
the optimal contract for type 2 agents has w12 = w22 , (ii) the incentive
compatability constraint for type 2 individuals
(1

p2 ) u w12 + p2 u w22

(1

p2 ) u w11 + p2 u w21

must bind and (iii) the participation constraint for the type 1 agents
(1

p1 ) u w11 + p1 u w21

u1

must bind.
8. Let us summarize what we have just seen.
(a) In the Principal-Agent model (with adverse selection), the principal is seeking how best to contract an agent but does not know
the specic type of the agent. Hence, in this model there is imperfect and asymmetric information (and common knowledge of
that fact). We assumed the principal to be risk-neutral and the
agent to be risk-averse. And, that there were two possible types
of agents: one of whom was better and one worse (for serving the
objectives of the principal).
(b) We rst studied what the principal could achieve if she knew the
type of the agent. This served as a benchmark. We saw that
this just reduced to the principal just dealing with the agent in
two separate market transactions. The solution was always on
the certainty line. The exact solution depended on the market
in which the principal operated. If she operated in a perfectly
42

competitive environment then the agent kept the expected value

of his endowment. If the principal operated as a monopolist, the
solution was the certainty equivalent of the initial endowment of
the agent. In both cases, type 1 agents received greater wealth
in equilibrium (and, hence, the type 2 agents would like to pass
themselves o as type 1 agents if they could).
(c) To better under the situation faced by the principal (in the asymmetric information model) we began by assuming the principal
was in a perfectly competitive market. This restricted the principals prot from the market to zero.
(d) There were two types of constraints faced by the principal in designing the contract: participation constraints and incentive compatibility constraints. The former stated that each type of agent
should get at least his as much utility from signing the contract
as he obtained from his outside option. The latter stated that
each type of agent would not be happier by pretending to be the
other type of agent.
(e) Given all the above, we noticed that one of the participation constraints and one of the incentive compatinility constraints was
binding. Specically, the worse types participation constraint
was binding. And, the contract oered to the better agent had
to be such that the worse type of agent found it in her interests to
sign the contract designed for him. That is, the participation constraint of the worse type was binding and incentive compatability
contraint of the the worse type had to be binding.
(f) Hence, the optimal contract for type 2 agents, w 2 , can be found
by simultaneously solving
E2 (~
x

w)
~ =0

and,
w1 = w2 :
That is,
x) :
w12 = w22 = E2 (~
And, the optimal contract for the type 1 agent, w 1 , was found by
solving
E1 (~
x w)
~ =0
43

and,
E2 u (w)
~ = u [E2 (~
x)] :
(g) Figuring out the two types of constraints helped us to (hugely)
simplify the contrained optimization problem faced by the principal. And, it allowed us to obtain the ideal contract for the principal, given his lack of information regarding the agents type.
(h) Now, we have to see how the solution of the information constrained problem compares with with that of the unconstrained
problem.
i. The fact that the worse type of agent has his participation
constraint binding means that he is no better o in the situation with asymmetric information than he was in a situation
of perfect information. He has the same utility and has the
same contract. Type 1 agents receive less utility than they
would in a situation of perfect information. This is because
they have to face additional risk as compared to the perfect
information situation and this is caused so that the contract
oered to them is unattractive to the worse, type 2, of agent.
ii. The principal in both cases got zero expected prots.
(i) In the monopoly case, relative to symmmetric information case,
type 2 gains and the monopolist principle loses, with the type 1
agents as before.
9. (Problem) Suppose there areptwo types of agents, with p1 = 0:2 and
p2 = 0:6. For both, u (w) = w. Reservation utility for type 1 agents
is u1 = 9 and for type 2 is u2 = 7. Probability of a type 1 agent in
the economy is = 0:9. The principal earns x1 = 100 in state 1 and
x2 = 40 in state 2. Characterize the optimal contracts for a perfectly
competitive principal.
(a) We know that in equilibrium the principal makes zero prots and
type 2 agents has equal wage in both states. Hence, the 2 equations that characterize the equilibrium contract for type 2 agents
is

0:4 100

w12

+ 0:6 40
44

w12
w22

= w22
= 0:

(1)
(2)

Let w12 = w22 = w2 , we have to solve

0:4 100

w2

+ 0:6 40

w2

= 0:

or
40 + 24 = 64 = w2 :
p
Hence, the agent gets utility 64 = 8 > u2 = 7, the reservation
utility of type 2 agents. The contract for the type 1 agent also
gives the principal zero expected prots, however, in his case the
incentive compatability constraint binds. Hence, the two equations characterizing the equilibrium contract for type 1 agent are
q
q
1
(3)
0:4 w1 + 0:6 w21 = 8
0:8 100

w11

+ 0:2 40

w21

= 0:

(4)

Hence, solving equations (3) and (4) gives us the constract for
type 1 agents so long as its solution gives him a utility greater
than 9. In fact, the solution gives her a utility of 9.29, and so
type 1 agents are happy with their contract.
10. (Problem) In a perfectly competitive adverse selection with two types of
agents, how would the equilibrium contracts of the two types of agents
change if they were to become more risk averse.
(a) The contract oered to the type 2 agents, which occurs at the
intersection of the zero prot line for such agents and the 45 degree
line, would not change. The contract oered to type 1 agents,
which occurs are the intersection of the zero prot line for such
agents and the indierence curve for such agents, would rise and
move to the left (as her IC would become more convex). That is,
it would oer a lower wage in state 1 and a higher wage in state
2 and, hence, be a less risky contract.

13

Moral Hazard

1. Whereas in adverse selection the principal could not observe the type
of the agent, in moral hazard the principal cannot observe the actions
taken by the agent. So, now there is only one type of agent and the
principal has to design only one contract.
45

2. We assume, as before, that the principal prefers state 1, so x1 > x2 .

We shall suppose the probability that any state occurs depends on the
eort e the agent puts in, and this is not observed by the principal.
Eort can be either e1 or e2 with e1 > e2 . And, that the probability
with which the bad state occurs p, is such that p (e1 ) < p (e2 ). That is,
the bad state occurs with lower probability when more eort is exerted
by the agent. We shall also suppose, as before, that the principal is
risk neutral whereas the agent is risk averse. The agent has utility
function
U (w; e) = u (w) d (e)
where u0 > 0, u00 < 0 and d0 > 0, where w denotes the money wage
oered by the principals contract. Hence, the expected utility of a
contract that oers wi in state i is
Ee [u (w)

d (e)] = [1 p (e)] u (w1 ) + p (e) u (w2 )

= Ee [u (w)]
~
d (e) :

d (e)

The principal is risk neutral and so her objective function is

Ee (~
x

w)
~ .

3. If the agent puts in high eort she get expected utility

[1

p (e1 )] u (w1 ) + p (e1 ) u (w2 )

d (e1 )

and, if she puts in low eort she gets

[1

p (e2 )] u (w1 ) + p (e2 ) u (w2 )

d (e2 ) :

Dene a function f (w) that gives the dierence in expected utility the
agents gets from exerting less to more eort. That is
f (w)

= f[1 p (e2 )] u (w1 ) + p (e2 ) u (w2 ) d (e2 )g

f[1 p (e1 )] u (w1 ) + p (e1 ) u (w2 ) d (e1 )g
= [p (e2 ) p (e1 )] [u (w2 ) u (w1 )] + d (e1 ) d (e2 ) :
:

Hence, if f (w) > 0 the agent prefers less eort and if f (w) < 0 she
prefers more eort. If f (w) = 0 the agent is indierent between the
contracts. Hence, f (w) captures the incentive compatibility of the
agent in this problem.
46

4. We want to plot the function f (w) = 0 in the CC space. To do so,

observe that
dw2
u0 (w1 )
jdf (w)=0 = 0
> 0:
dw1
u (w2 )
Hence, the slope of the function is positive. Further note that f (w) = 0
implies that
[p (e2 )

p (e1 )] [u (w2 )

u (w1 )] = d (e2 )

d (e1 ) :

But, as d0 > 0,
d (e2 )

d (e1 ) < 0:

Hence,
[p (e2 )

p (e1 )] [u (w2 )

u (w1 )] < 0:

As p (e2 ) > p (e1 ), the above inequality implies

u (w2 ) < u (w1 ) :
But, as u0 > 0, we have that
w1 > w2 :
So, along f (w) = 0 we must have w1 > w2 . As, u00 < 0, when w1 > w2
we must have
dw2
u0 (w1 )
< 1:
jdf (w)=0 = 0
dw1
u (w2 )
That is, the slope of f (w) = 0 is everywhere less than 1. Now we are
ready to draw this function. It lives in the area where w1 > w2 and
has a positive slope less than 1.
5. Now, lets draw indierence curves Eei [u (w)],
~ i = 1; 2, that both intersect at some point, A, along f (w) = 0. Such indierence curves only
reects the money or wage part of the preferences and we know they
will be downward sloping and convex to the origin (because u0 > 0
and u00 < 0). As w is independent of d (e) total utility U (w; e) =
u (w) d (e) is also constant along these ICs.
(a) We know the individual is indierent between both situations
when their total utility curves intersect the certainty line at the
47

same point. Now, we have two curves (which only represent

u (w)) which intersect the certainty line at dierent points, with
the Ee1 (u) curve crossing it higher. However, if we drew total utility curves they would intersect the certainty curve at the
same point if we take into account the Ee1 (u) curve woud have a
greater drop as it involves a greater d (e). That is, the situation
graphed has Ee1 [u (w)] d (e1 ) = Ee2 [u (w)] d (e2 ), but since,
d (e1 ) > d (e2 ) we have Ee1 [u (w)] > Ee2 [u (w)].
(b) Hence the higher up the point A is in the graph, the more preferred
the point is. And, if the two curves (Ee1 [u (w)] and Ee2 [u (w)])
do not intersect on f (w) = 0 then the one which intersects higher
is the more preferred one.
(c) As the agent is indierent between both eort levels on the f (w) =
0 line, he is not indierent the eort levels o the line. Clearly,
if the contract lay on the certainty line (which is to the up-left of
f (w) = 0), then the individual would prefer low eort (as eort
has no impact of probability of getting a dierent wage in the
dierent states). This is true for all up-left points between the
two curves. And, to the down-right of f (w) = 0, where there is
greater dierence between the wages between the two states, the
agent would prefer having a larger probability of the higher wage
and so prefers the higher eort.
6. Now, lets draw the set of all contracts (~
x; w)
~ and eort combinations
which leave the principal indierent. Given she is risk neutral, this is
given by the equation,
p (e1 ) (x2

w2 )+(1

p (e1 )) (x1

w1 ) = p (e2 ) (x2

w2 )+(1

p (e2 )) (x2

which simplies to,

g (w) := (x2

x1 ) + (w1

w2 ) = 0:

Clearly, the slope of g (w) = 0 is 1 in (w1 w2 ) space (i.e., the CC

diagram). It is parallel to the certainty line, intersecting the horizontal
axis at x1 x2 .
(a) Draw g (w) = 0 and the two expected prots lines Ee1 (~
x w)
~ =
Ee2 (~
x w)
~ in the CC diagram. All three lines intersect at a
point, B. Note, Ee1 (~
x w)
~ is steeper than Ee2 (~
x w).
~
48

w2 ) ;

(b) The lower we are in g (w) = 0 the more preferred point it is of the
principal.
(c) At points to the up-left of g (w) = 0 the principal prefers high
eort and point to the down-right she prefers low eort (at such
points the wage w1 is too high in comparison to how desriable she
nds the better state)
7. Now we are ready to study the principal-agent (moral hazard) problem
when the market of principals is perfectly competitive. So, the
principal is restricted to making zero prot, so she is living on the
line Eei (~
x w)
~ = 0. And, we have to satisfy the participation and
incentive compatability constraints of the agents.
(a) Suppose the principal is happy demanding low eort. Then she
lives on the line Ee2 (~
x w)
~ = 0. The point the agent, who is
happy providing low eort, most prefers on this line is the point
at which it crosees the certainty line, call is A . Such a point is
to the up-left of the f (w) = 0 line. But, is A the best contract
for the principal? Well, since the principal is restricted to making
zero prot A mus be a best response, even though there might
be others (say, involving high eort).
(b) Lets see what can be attained if the principal lives on Ee1 (~
x w)
~ =
0. These are the set of points that give the principal zero prot
when the agent chooses high eort e1 . The agent, now, must live
on or to the right-botton of f (w) = 0. But, within this group of
contracts, the agent prefers the contract closest to the certainty
line. Hence, she will choose to live on f (w) = 0. Hence, the
solution to this problem, of the optimal contract for the agent to
choose e1 lies at the intersection of Ee1 (~
x w)
~ = 0 and f (w) = 0.
Call this point B . Of course, the principal is indierent between
A and B .
(c) Now, will the agent choose A or B or either of them? That is,
should the principal oer A or B or both. The answer to this
requires checking the agents preferences between these two points.
It would be that the agents indierence curve, for low eort Ee2 u,
passing through A (which is on the certainty line) passes above or
below of on B (which is on the f (w) = 0 line and its intersection
49

with Ee1 u). As as preferences are purely determined by where

the agents indierence curves intersect the f (w) = 0 line, this
will give the answer. If Ee2 u going through A passes f (w) = 0
at the point where Ee1 u passes through f (w) = 0 (which is at B )
then the agent is indierent between the two points. Otherwise,
it depends on whether Ee2 u intersects f (w) = 0. If it intersects
at a point that is higher (lower) than B , the principal need oer
only one contract, because the agent prefers A (respectively, B ).
(d) Note that it is always possible for the principle to design a contract
which makes the agent prefer high eort. However, whether it is
protable for the principal to do so depends on how much extra
w, in terms of expected payo, the principal has to oer the agent
for this.
(e) To summarize:
i. If the optimal contract demands the lower eort e2 , then it
oer gives the agent a certain wage (w1 = w2 ).
ii. If the optimal contract demands the higher eort e1 , then it
oers the agent a higher wage in state 1 than in state 2 (that
is, a risky contract is oered: e.g., a lower wage plus a bonus
if state 1 is realized).
iii. If the equilibrium contract demands higher eort e1 then the
incentive compatability constraint binds, otherwise it does
not.
iv. Compared to the same optimal contract with symmetric and
perfect information, the principal is as well o in both (earning a zero prot). If the contract demands low eort the agent
is also as well o as in the case of full information. However,
in case the contract demands high eort, the agent is not as
well o as in the case of full information.
8. We are now ready to tackle the problem when the principal is a
monopolist.
(a) Whatever the equilibrium contract oered, the participation constraint in binding.

50

(b) The optimal contract for low eort is located at the intersection of
the reservation utility indierence curce, conditional on low eort,
and the certainty line.
(c) The optimal contract for high eort is located at the intersection
of the reservation utility indierence curve, conditional on high
eort, and the f (w) = 0 line.
(d) The incentive compatability constraint binds if, in equilibrium,
the principal demands high eort. Otherwise, it does not bind.
(e) Compared to the situation of full information, the agent is indifferent, regardless of the level of eort demanded. If low eort is
demanded then the principal is also indierent, however, if high
eort is demanded then the principal is worse o.
p
9. (Problem) An agent has utility function w ei , where w denotes
his wage and ei his eort, which can either be e1 = 1 or e2 = 0. If
ei = 1 then the probability of the bad state is p = 1=3 and if ei = 0
the probability of the bad state is p = 2=3. The risk neutral principal,
who operates in a perfectly competitive market, earns 7 in the bad state
and 13 in the good state. What are the rst order conditions that the
optimal contract.(w 1 ; w 2 ) has to satisfy? Be careful that you state
which constraints need to bind at the optimum.
(a) The contract (wage oer) for low eort occurs at the intersection
of of the low eort expected value equals 0 line and the certainty
line. Hence, the two equations the that charaterize the type 2
contract are
w12
1
13
3

w12

2
7
3

w22

= w22

(5)

= 0

(6)

Combining the two constraints, and letting w12 = w22 = w

need to solve,
2
7
3

w2

1
13
3

w2

= 0:

Or,
w2 =

14 13
27
+
=
= 9:
3
3
3
51

we

p
So, at this contract the agent gets utility 9 0 = 3. The
high eort contract w1 occurs at the intersection the the line
which gives the principal an expected value of zero and where the
incentive compatability constraint binds. This occurs when
1
7
3

w21

2
13
3

w11

=0

(7)

and,

q
q
q
q
2
1
1
2
w21 +
w11 =
w21 +
w11
1
(8)
3
3
3
3
This solves to w11 = 16 and w21 = 1. The agents expected utility
from this contract is
1p
2p
1 8
1 = 2:
1+
16 1 = +
3
3
3 3
The four equations dene the answer. You will nd in equilibrium
only the low wage contract will be oered (as both types of agents
get a higher utility with that one).
10. (Problem) Suppose we have a principal p
who is a monopolist. The
agents have utility functions u (w; e) = 2 w ei , where e1 = 2e and
e2 = e, where e > 0. The agents has reservation utility u = 10. If
the agent uses high eort e1 , then the probability of the bad state is
p1 = 0:2 and if she uses e2 then probability of the bad state is p2 = 0:6.
The principal earns x1 = 200 in state 1 and x2 = 50 in state 2. Find
the optimal contracts for low and high eort as functions of e. For
what values of e does the principal prefer e1 and for what values of e
does she prefer e2 ?
(a) We know the low eort contract wl has to be risk free (on the 45
degree line) and oer utility to the agent
p
e = u = 10:
u (w; e) = 2 wl
Hence,

p
10
wl =

e
2

e
:
2

=5

Hence,
wl = 25 + 5e +
52

e2
4

The expected prot from this contract is

0:4 200

wl

wl

+ 0:6 50

= 80 + 30
= 110
85

wl
25

5e

5e

e2
4

e2
:
4

For the high eort contract, the incentive compatability constraint

must bind along the participation constraint. Hence,
q
q
0:4 2 w1l
e + 0:6 2 w2l
e
= 10
q
q
0:8 2 w1l
2e + 0:2 2 w2l
2e
= 10:
These can be solved to give
wh = w1h ; w2h

25 +

25
50
e + e2 ; 25 :
4
16

The expected prot for the principal from this contract is

145

10e

5 2
e:
4

Expected prots with the high and the low eort contracts intersect at e
5:639. For all e < e the principal prefers the
high eort contract and the low eort one otherwise. (And, for
e > 10:98 she prefers not to participate).

14

Exercises and Problems

1. Dene a person who is said to be risk averse

(a) A person if said to be risk averse if she prefers the expected value
of a distribution to the distribution itself for all distributions.
2. Who is an expected utility maximizer (give a precise denition)?
53

(a) A EU maximizer of someone who evaluates distribution by the

expected utility criterion and chooses the distribution which maximizes expected utility. The expected utility criterion ranks distributions by calculating the expected utility of the outcomes.
Equivalently, an expected utility maximizer of someone whose
preferences are transitive, complete, continuous and satisfy the
independence axiom.
3. State the (von Neumann and Morgenstern) independence axiom.
(a) Preferences over lotteries in (X) are said to satisfy the vNM
independence axiom if for all l; l0 ; l00 2 (X), and all 2 [0; 1] ;
l

l0 () l + (1

) l00

l0 + (1

) l00

4. In the Marshak-Machina triangle (in p3 p1 space, with p3 giving the

probability of getting $3 and p1 giving the probability of $1) draw the
indierence curves of
(a) a person who satises the independence axiom (but not, necessarily, the other vNM axioms).
(b) a person who satises all of the vNM axioms.
(c) a risk-loving expected utility maximizer.
i. Indierence curves are parallel straight lines.
ii. Upward sloping parallel straight lines
iii. Upward sloping parallel straight lines with slope less than the
45 degree line (which is the slope of the iso-expected value
lines).
5. In the Marshak-Machina triangle (in p3 p1 space, with p3 giving the
probability of getting $3 and p1 giving the probability of $1) draw
(a) the iso-expected utility line going through the lottery l = (1=3; 1; 1=3; 2; 1=3; 3) :
(b) highlight all the points that are second order stochastically dominated by l.
(c) highlight a point that every expected utility maximizer (with an
increasing utility function) would prefer to l.
54

i. This solution requires pictures. Refer to class.

6. What is the certainty
equilivalent of Jill who have (Bernoulli) utility
p
function u (x) = x, x > 0, for l = (1=2; 4; 1=2; 25).
(a) Jack is willing to pay a higher risk premium than Jill for l =
(1=2; 4; 1=2; 25). What can you concludes about Jacks preferences (relative to Jills).
p
p 2
i. CE(u; l) = 1=2 4 + 1=2 25 = (1 + 2:5)2 = (3:5)2 = 12:25
A. Jack is not less risk averse than Jill.
7. Jill has straight line indierence curves in the contingent claims diagram. What can we conclude about Jill
(a) She is risk averse
(b) She is risk neutral
(c) She is risk loving
(d) None of the above
(e) All of the above
i. b) : she is risk neutral. (a) and c) are not incorrect, but b)
is a better answer)
8. Jacks indierence curves are more convex than Jills in the CC diagram. Is Jack
(a) more risk averse than Jill
(b) less risk averse than Jill
(c) none of the above
(d) all of the above
(e) other
i. a) : Jack if more risk averse than Jill.

55

9. Suppose a monopolist faces inverse demand function p (q) = a bq

and cost function c (q) = cq, where a; b; c are positive constants and
p (respectively, q) represents price (resp., output). The monopolist is
risk averse with increasing (Bernoulli) utility function u. Now suppose
he faces production cost uncertainty, so, c (q) = cl with probability p
and c (q) = ch with probability (1 p). (i) Calculate optimal production in the risky environment. (ii) How does the risky optimal
output compare to the optimal output that would arise in a certain
environment if marginal cost were equal to pcl + (1 p) ch ?
(a) (i) Monopolist wants to choose q to maximize
pu ((a
= pu aq

bq) q cl q) + (1 p) u ((a
bq 2 cl q + (1 p) u aq

bq) q ch q)
bq 2 ch q :

The FOC is,

p (a

cl ) u0 aq

2bq

bq 2

cl q +(1

p) (a

In a certain environment with MC = pcl + (1

olist maximizes
u ((a
= u aq

2bq

ch ) u0 aq

bq 2

p) ch , the monop-

bq) q (pcl + (1 p) ch ) q)
bq 2 (pcl + (1 p) ch ) q :

The FOC is,

(a

2bq

(pcl + (1

p) ch )) u0 aq

bq 2

(pcl + (1

p) ch ) q = 0:

Now, carefully compare the imoplications of the FOC (using the

concavity of the utility function). You will see that optimal production for the risk averse producer is lower is the risky environment than in the certain environment. (please ll in the details
assuming ch > cl ).
10. In the CC space, draw the certainty line. Now plot a point in which the
individuals suers a loss in state 1 (which is plotted on the horizontal
axis). Call the point A. Assume the agent is risk averse and draw his
indierence curve going through A. Assume the probability of a loss
56

ch q = 0:

is p. Draw the iso-expected value line going through A. Suppose an

insurance company oer insurance cover per unit of loss at rate q = p.
Plot the point on the diagram which represents how much insurance
the individual would buy. Now suppose that q > p. Illistrate what q
must be in the diagram for the individual to buy no insurance.
(a) For diagram, refer to class.
11. Bernoulli suggested that if people had (Bernoulli) utility function u (x) =
log x then we would get a satisfactory resolution of the St. Petersburg
paradox. What is the (Arrow-Pratt) measure of relative risk aversion
of this utility function.
(a) u0 (x) = x 1 . u00 (x) =

x 2 . Hence, RR (x) =

x
x

2
1

x=1

12. Argue, maybe with an example, that decreasing (Arrow-Pratt) absolute risk aversion if consistent with constant (Arrow-Pratt) relative
risk aversion. The above example (u (x) = log x), for example, shows
that RA (x) decreases while RR (x) is constant.
(a) RR (x) = RA (x) :x. Hence, if RA (x) decreases at the same rate
at which x increases we have constant relative risk aversion.
13. If people cannot visualise (or calculate or understand) more than the
outcomes of 20 tosses of a coin then would the St.Petersburg gamble
not lead to a paradox? Why or why not?
(a) The paradox only arises because the expected value of the gamble involves the addition of an innite number of (small) positive
terms. If the agent can only add 20, then the paradox would
disappear (and people could not visualize such a gamble).
14. Assuming the (von Neumann and Morgenstern) independence axiom
implies that indierence curves in the Machina-Marshak triangle are
straight lines. Prove or disprove.
(a) Indiernce curves are straight lines if whenever l l0 we have that
l
l + (1
) l0 for all 2 [0; 1]. Now, the independence axiom
for indierence implies that for all l; l0 ; l00 and for all a 2 [0; 1],
l

l0 , l + (1

57

) l00

l0 + (1

) l00 .

As l00 is arbitrary in the IA, we can choose l00 = l. Then the IA

states
l l0 , l
l0 + (1
) l:
Which gives us that indierence curves are straight lines.
15. Draw the Machina-Marshak triangle, with the probability of 3 on the
vertical axis and the probability of 1 on the horizontal axis. Indicate
all the point that second order stochastically dominate (0:5; 0:5) in this
diagram. Explain.
(a) See class.
16. Expected utility maximizers with strictly increasing and strictly concave utility function like higher means and dislike higher variance. True
or false. Explain.
(a) False. Expected utility maximizers care for all moments of the
distribution, not only the rst 2.
17. Draw continegent claims (CC) diagram. Assume that the individual
initially has more wealth in state 1 than in state 2. Pick any suitable initiall wealth and label it A and draw the iso-expected value line
going through this point. Draw also the certainty line. Draw the
indierence curves of a strictly risk loving agent through that point.
In the diagram, what is the risk premium she is willing to pay/oer?
Explain.
(a) See class.
18. A risk neutral entrepreneur facing some cost shocks (as the prices of his
inputs are uctuating and out of his control). Suppose his (inverse)
demand curve is p (q) = a bq, where q is his output, p is the price of his
output and a and b are positive constants. Suppose his cost function
is either c (q) = c0 + ch q or c (q) = c0 + cl q each with equal probability,
where c0 ; ch , and cl are positive constants with cl < ch . How much
does the entrepreneur choose to maximize his expected prots.

58

(a) The entrepreneur maximizes

E( ) =

1
[(a
2

= (a

bq) q
bq) q

(c0 + cl q)] +
c0 +

1
[(a
2

bq) q

(c0 + ch q)]

1
(cl + ch ) q
2

The FOC for the above problem are

a

1
(cl + ch ) = 0;
2

2bq

or,
q =

1
2

(cl + ch )
:
2b

19. Draw the Edgeworth box for risk, in a situation where there is no
aggregate uncertainty. Label all sides of the box. Draw, in the box,
the contract curve when both individuals are strictly risk averse.
(a) See class.

59