Uncertainty: Choose The One Alternative That Best Completes The Statement or Answers The Question

CHAPTER 17 Uncertainty
MULTIPLE CHOICE
Choose the one alternative that best completes the statement or answers the question.
1) Although he is very poor, Al plays the million-dollar lottery everyday because he is certain
that one day he will win. Al makes this calculation based upon
A) the frequency of past outcomes.
B) subjective probability.
C) knowledge of all possible outcomes.
D) tossing a coin.
Answer: B
Diff: 0
Topic: Degree of Risk
2) If there are 10,000 people in your age bracket, and 10 of them died last year, an insurance
company believes that the probability of someone in that age bracket dying this year would
be
A) 0.
B) .001.
C) .0001.
D) 1,000.
Answer: B
Diff: 0
3) People in a certain group have a 0.3% chance of dying this year. If a person in this group
buys a life insurance policy for $3,300 that pays $1,000,000 to her family if she dies this year
and $0 otherwise, what is the expected value of a policy to the insurance company?
A) $0
B) $300
C) $3,000
D) $3,300
Answer: B
Diff: 1
319
Chapter 17/Uncertainty
4) Expected value represents

A) the actual payment one expects to receive.
B) the average of all payments one would receive if one undertook the risky event many
times.
C) the payment one receives if he or she makes the correct decision.
D) the payment that is most likely to occur.
Answer: B
Diff: 2
5) On any given day, a salesman can earn $0 with a 20% probability, $100 with a 40%
probability, or $300 with a 20% probability. His expected earnings equal
A) $0.
B) $100 because that is the most likely outcome.
C) $100 because that is what he will earn on average.
D) $200 because that is what he will earn on average.
Answer: C
Diff: 2
probability, or $300 with a 50% probability. His expected earnings equal
A) $0.
B) $100.
C) $150.
D) $170.
Answer: D
Diff: 1
7) Sarah buys little stuffed animals for $5 each. They come in different varieties. If the producer
stops making (retires) a certain variety, a stuffed animal of that variety will be worth $100;
otherwise it is worth $0. There is 50% chance that any variety will be retired. When Sarah
buys her next stuffed animal, the expected profit is
A) $50.
B) $47.50.
C) $45.00.
D) $0.
Answer: C
Diff: 1
320
otherwise it is worth $0. There is 50% chance that any variety will be retired. What is the
value to Sarah of knowing ahead of time whether a variety will be retired?
A) $50
B) $5
C) $2.50
D) $0
Answer: C
Diff: 2
9) If a payout is certain to occur, then the variance of that payout equals

A) zero.
B) one.
C) the expected value.
D) the expected value squared.
Answer: A
Diff: 1
10) A lottery game pays $500 with .001 probability and $0 otherwise. The variance of the payout
is
A) 15.8.
B) 249.50.
C) 249.75.
D) 499.
Answer: C
Diff: 1
11) All else held constant, as the variance of a payoff increases, the
A) expected value of the payoff increases.
B) risk of the payoff increases.
C) expected value of the payoff decreases.
D) risk of the payoff decreases.
Answer: B
Diff: 1
321
Figure 17.1
12) Figure 17.1 shows Bob's utility function. He currently has $100 of wealth, but there is a 50%
chance that it could all be stolen. The midpoint of the chord that runs from zero and
intersects the utility function where wealth is 100, represents Bob's
A) risk premium.
B) expected utility of receiving $50 with certainty.
C) expected utility of receiving $0 50% of the time and $100 50% of the time.
D) risk neutrality.
Answer: C
Diff: 1
Topic: Decision Making Under Uncertainty
chance that it could all be stolen. Bob's expected utility is
A) a.
B) b.
C) c.
D) d.
Answer: A
Diff: 1
322
chance that it could all be stolen. Bob is
A) risk averse.
B) risk neutral.
C) risk loving.
D) risk premium.
Answer: A
Diff: 1
chance that it could all be stolen. Bob's expected wealth is
A) $0.
B) $50.
C) $75.
D) $100.
Answer: B
Diff: 1
chance that it could all be stolen. To reduce the chance of theft to zero, Bob is willing to pay
A) $20.
B) $50.
C) $70.
D) $80.
Answer: C
Diff: 1
chance that it could all be stolen. Over and above the price of fair insurance, what is the risk
premium Bob would pay to eliminate the chance of theft?
A) $0
B) $20
C) $30
D) $50
Answer: B
Diff: 1
323
chance that it could all be stolen. Living with this risk gives Bob the same expected utility as
if there was no chance of theft and his wealth was
A) $0.
B) $20.
C) $30.
D) $50.
Answer: C
Diff: 1
chance that it could all be stolen. What is the most Bob would pay for insurance that would
replace his $100 should it be stolen?
A) $30
B) $50
C) $70
D) $75
Answer: C
Diff: 1
chance that it could all be stolen. If Bob could keep $50 with certainty, his utility would be
A) a.
B) b.
C) c.
D) d.
Answer: B
Diff: 1
chance that it could all be stolen. Bob is risk averse because
A) his utility function is concave.
B) he has diminishing marginal utility of wealth.
C) he is willing to pay a premium to avoid a risky situation.
D) All of the above.
Answer: D
Diff: 1
324
chance that it could all be stolen. Bob is risk averse because
A) his utility function is convex.
B) he has negative marginal utility of wealth.
C) he is willing to pay a premium to avoid a risky situation.
D) All of the above.
Answer: C
Diff: 1
chance that it could all be stolen. Bob will buy theft insurance to cover the full $100
A) as long as it does not cost more than $25.
B) as long as it does not cost more than $50.
C) as long as it does not cost more than $70.
D) at any price.
Answer: C
Diff: 1
24) If a person is entertained by gambling, then

A) she is not risk averse.
B) does not understand the concept of a fair game.
C) she may gamble even if it is an unfair game.
D) she will definitely not buy automobile insurance.
Answer: C
Diff: 1
25) If a person is risk neutral, then she

A) is indifferent about playing a fair game.
B) will pay a premium to avoid a fair game.
C) has a horizontal utility function.
D) has zero marginal utility of wealth.
Answer: A
Diff: 1
325
26) John derives more utility from having $1,000 than from having $100. From this, we can
conclude that John
A) is risk averse.
B) is risk loving.
C) is risk neutral.
D) has a positive marginal utility of wealth.
Answer: D
Diff: 1
27) John's utility from an additional dollar increases more when he has $1,000 than when he has
$10,000. From this, we can conclude that John
A) is risk averse.
B) is risk loving.
C) is risk neutral.
D) has a negative marginal utility of wealth.
Answer: A
Diff: 1
28) Bob invests $50 in an investment that has a 50% chance of being worth $100 and a 50%
chance of being worth $0. From this information we can conclude that Bob is not
A) risk loving.
B) risk neutral.
C) risk averse.
D) rational.
Answer: C
Diff: 1
chance of being worth $0. From this information we can conclude that Bob is
A) risk loving.
B) risk neutral.
C) risk averse.
D) irrational.
Answer: A
Diff: 1
326
chance of being worth $0. From this information we can conclude that Bob is
A) risk loving.
B) risk neutral.
C) risk averse.
D) Any one of the three above.
Answer: D
Diff: 1
31) The Friedman-Savage utility function can explain why

A) people buy automobile insurance.
B) somebody becomes addicted to gambling.
C) people become more risk averse as their wealth increases.
D) people place small bets to have a chance at winning a large amount.
Answer: D
Diff: 2
32) Buying a diversified mutual stock fund allows you to

A) completely avoid all types of risk.
B) avoid only random, unsystematic risk.
C) avoid only systematic risk.
D) avoid risk only when all the stock prices are perfectly correlated.
Answer: B
Diff: 1
Topic: Avoiding Risk
33) The ability of diversification to reduce risk

A) is greater the more negatively correlated the two events are.
B) is greater the more positively correlated the two events are.
C) is greater the more uncorrelated the two events are.
D) is greater the more risk averse the individual is.
Answer: A
Diff: 2
327
34) If two events are perfectly positively correlated, then

A) diversification is not necessary since there is no risk.
B) diversification eliminates all risk.
C) diversification does not reduce risk at all.
D) diversification only cuts the risk in half.
Answer: C
Diff: 2
35) Many people do not fully insure against risk because

A) they are risk averse.
B) the insurance companies are all crooks.
C) the insurance offered is less than fair.
D) the insurance offered is more than fair.
Answer: C
Diff: 1
36) If fair insurance is offered to a risk-averse person, she will

A) buy enough insurance to eliminate all risk.
B) not buy any insurance because it is overpriced.
C) not buy any insurance since the marginal utility of the amount of the payment is positive.
D) buy enough insurance to cover about half of the possible loss.
Answer: A
Diff: 1
37) Which of the following losses to an individual would an insurance company NOT cover?
A) The person's automobile is stolen.
B) Fire destroys the person's home.
C) The person's father dies.
D) The person's country is invaded.
Answer: D
Diff: 1
328
38) Insurance companies do not cover losses that would

A) happen to all of the policyholders at once.
B) happen with a very low probability.
C) happen to just a handful of policyholders.
D) happen with uncertainty.
Answer: A
Diff: 1
39) Risk-averse individuals make risky investments

A) never.
B) when the investment's return exceeds the return on a nonrisky investment.
C) when the investment's return adequately compensates for the risk.
D) only when they are feeling irrational.
Answer: C
Diff: 1
Topic: Investing Under Uncertainty
40) If an individual makes her investment decisions based solely on the Net Present Value
criterion, one can conclude that she is
A) risk averse.
B) risk neutral.
C) risk loving.
D) extremely wealthy.
Answer: B
Diff: 1
41) The rate of return on bonds is lower than on stocks over time because
A) bond holders cannot diversify.
B) bonds have a lower standard deviation in returns.
C) stocks have less nondiversifiable risks than bonds.
D) bonds are subject to more random risks than stocks.
Answer: B
Diff: 0
329
42) Empirical evidence suggests that usury laws

A) help poor consumers by lowering the interest rate they pay.
B) hurt poor consumers by limiting their ability to borrow.
C) keep interest rates low.
D) limit the amount borrowed by wealthier consumers.
Answer: B
Diff: 1
43) Usury laws result in banks making less credit available to lower-income households because
A) higher-income households will pay a higher interest rate than lower-income households.
B) loans made to higher-income households have no risk.
C) loans to lower-income households are riskier than loans to higher-income households.
D) the regulated interest rate does not adequately compensate the bank for the risk of
the loan to a lower-income household.
Answer: D
Diff: 2
44) Without usury laws, banks will

A) charge very high interest rates to all borrowers.
B) charge higher interest rates to riskier borrowers than to safer borrowers.
C) charge very low interest rates to all borrowers.
D) face no demand for loans.
Answer: B
Diff: 1
330
Figure 17.1
45) Figure 17.1 shows Bob's utility function. He currently has $50 and is considering investing
all of it in an investment that has a 50% chance of being worth $100 and a 50% chance of
being worth $0. Bob will
A) definitely make the investment because the expected utility of the investment exceeds the
utility of his $50.
B) definitely not make the investment because the expected utility of the investment is less
than the utility of his $50.
C) definitely make the investment because he is indifferent between having $50 and having
an investment with an expected value of $50.
D) definitely not make the investment because he is indifferent between having $50 and
having an investment with an expected value of $50.
Answer: B
Diff: 1
46) Figure 17.1 shows Bob's utility function. He currently has $50 and is considering an
investment that has a 50% chance of being worth $100 and a 50% chance of being worth $0.
Bob will make the investment
A) if it costs less than $50.
B) if it costs less than $30.
C) if it is a fair game.
D) under no circumstances.
Answer: B
Diff: 2
331
TRUE/FALSE/EXPLAIN
1) Expected value represents the average of all outcomes if one were to undertake the risky
event many times over and over again.
Answer: True. The expected value is not expected on any one outcome, but the average of
many outcomes.
Diff: 0
2) If a person is risk averse, then she has negative marginal utility of wealth.
Answer: False. The marginal utility of wealth is positive for the risk-averse person; however,
marginal utility diminishes as wealth increases.
Diff: 1
3) A fair game is a game in which the chances are 50-50 that you win or lose.
Answer: False. A fair game is one in which the expected value of the payoff to the player is
equal to the cost of playing.
Diff: 1
4) If a person willingly plays an unfair game that is not in his favor, he is risk loving.
Answer: False. While that could be the reason, there are others. Either the person likes
gambling for entertainment reasons, or the person does not understand the probabilities
associated with each payout.
Diff: 1
5) If insurance is fairly priced, a risk-averse individual will purchase enough insurance to cover
the full amount of the possible loss.
Answer: True. If the insurance is fairly priced, the risk-averse individual's expected utility is
maximized when fully covered.
Diff: 1
PROBLEMS
probability, or $300 with a 20% probability. Calculate the expected value and variance of his
earnings, and interpret.
332
Answer: E(X) = (0 * .2) + (100 * .4) + (300 * .2) = $100

Variance(X) = .2(0 - 100 )2 + .4(100 - 100 )2 + .2(300 - 100 )2 = 2000 + 0 + 8000 = 10,000.
E(X) tells us that her earnings will average $100 per day if she stays at this job over a long
time period. The variance is a measure of how risky her income is.
Diff: 1
2) Explain why the variance of an investment is a useful measure of the risk associated
with it.
Answer: The variance provides a measure of the spread of the probability distribution around
the expected value of the investment. That is, if the variance is relatively small, the expected
value is more likely to be the actual value. If the variance is relatively large, the expected
value is less likely to be the actual value. Since something that is more uncertain is said to be
more risky, and something with a higher variance is more uncertain, the variance measures
risk.
Diff: 1
otherwise it is worth $0. There is 25% chance that any variety will be retired. For the
purchase of an individual animal, what is the value to Sarah of knowing ahead of time
whether or not that variety will be retired?
Answer: If Sarah did not know whether a variety is to be retired, her expected value of a
purchase is (.75 * -5) + (.25 * 95) = -3.75 + 23.75 = $20.
If she knows ahead of time that a variety won't be retired, she won't buy one. So, her
expected value becomes (.75 * 0) + (.25 * 95) = $23.75.
The information that a variety will or will not get retired is worth $3.75 to her.
Diff: 2
4) Johnny owns a house that would cost $100,000 to replace should it ever be destroyed by fire.
There is a 0.1% chance that the house could be destroyed during the course of a year.
Johnny's utility function is U = W0.5. How much would fair insurance cost that completely
replaces the house if destroyed by fire? Assuming that Johnny has no other wealth, how
much would Johnny be willing to pay for such an insurance policy? Why the difference?
Answer: Fair insurance would cost (0.001 * $100,000) = $100. Johnny's expected utility
without insurance equals (.001 * 00.5) + (.999 * 100,0000.5) = 315.91. He can receive this
level of utility with certainty if he had risk-free wealth of $99,800.10. Thus, he is willing to
pay $199.90 for insurance. He is willing to pay more than the fair price because he is risk
averse.
Diff: 2
333
5) For the utility function U = Wa, what values of a correspond to being risk averse, risk
neutral, and risk loving?
Answer: 0 < a < 1 implies risk averse.

a = 1 implies risk neutral.
a > 1 implies risk loving.
Diff: 1
6) What type of risk behavior does the person exhibit who is willing to pay $5 for the
chance to bet $60 on a game where 20% of the time the bet returns $100, and 80% of the
time returns $50? Explain.
Answer: This person is risk preferring. The bet is fair. The expected wealth of the person is
the same whether or not the bet is made. However, this person is willing to pay $5 to make
this fair bet.
Diff: 1
Figure 17.1
7) Bob's utility function is shown in Figure 17.1. He currently has $100 worth of property, but
there is a 50% chance that all of it will be stolen. An insurance company offers to reimburse
Bob for his loss if the money is stolen. What is the most that Bob would pay for such a
policy? Explain.
Answer: The risky life leaves Bob with expected utility that could be had from a certain $30.
Thus, he is willing to part with $70 to insure himself against such a loss.
Diff: 2
334
Figure 17.2
8) Steven currently has wealth of $10,000. He is risk averse about losing any of his wealth, but
risk loving about adding to his wealth. Draw his utility function.
Answer: See Figure 17.2

Diff: 1
9) Why does diversification fail to reduce risk when the returns of the two investments
purchased are perfectly positively correlated?
Answer: If two returns are perfectly positively correlated, then what happens to one in terms
rising or falling will happen to the other.
Diff: 1
10) Distinguish between risk that can be reduced through diversification and risk that cannot be
reduced through diversification.
Answer: Risk that cannot be diversified away affects all investments equally. Examples
would include war and natural disasters. Risk that can be reduced through diversification
includes changes to the value of an investment that is not perfectly positively correlated with
the values of other investments.
Diff: 1
335
11) Explain why insurance companies usually do not offer earthquake insurance.
Answer: Insurance companies diversify their risk by covering many people who mostly have
uncorrelated expected losses. However, an earthquake usually causes losses to many people
in an area. Thus, earthquake losses are very much positively correlated and cannot be easily
diversified. Insurance companies do not want to face losses they cannot easily diversify.
Diff: 1
12) Alvin's utility function is U = W. Barry's utility function is U = W2. Carl's utility function is
U = W0.5. Each has wealth of only $100. An investment of that $100 has a 10% chance of
netting $1,000 and a 90% chance of netting a loss of that $100. Who among the three will
make the investment?
Answer: Carl's expected utility is (0.1 * 1,0000.5) + (0.9 * 00.5) = 3.16. This is less than his
current utility of 10. He will not make the investment. Alvin's expected utility is (0.1 * 1,000)
+ (0.9 * 0) = 100. This equals his current utility of 100. Barry's expected utility is (0.1 * ,
10002) + (0.9 * 02) = 100,000. This exceeds his current utility of 10,000. Barry is risk loving
and will make the investment. Carl is risk averse; he will not. Alvin is risk neutral; the
investment is a fair game, and he is indifferent about making the investment.
Diff: 2
13) Explain why the rate of return from investing in stocks is higher than from
investing in bonds.
Answer: Most people are risk averse. They only make investments if the rate of return on a
risky investment exceeds the rate of return on a less risky investment by a risk premium.
Stock are more risky because they have more nondiversifiable risks. Thus, stocks must
include a risk premium in their return to attract investors.
Diff: 1
14) Why would a usury law result in banks making less credit available to low-income
households?
Answer: Without restrictions, banks would charge a higher rate to riskier borrowers. Lower-
income households pose a greater risk of repayment than do higher-income households. With
a usury law, a ceiling on interest rates is imposed on banks. Banks grant loans to the least
risky applicants. As a result, less credit is made available to the most risky applicants, who
tend to be lower-income households.
Diff: 2
336

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CHAPTER 17 Uncertainty

4) Expected value represents

9) If a payout is certain to occur, then the variance of that payout equals

24) If a person is entertained by gambling, then

25) If a person is risk neutral, then she

31) The Friedman-Savage utility function can explain why

32) Buying a diversified mutual stock fund allows you to

33) The ability of diversification to reduce risk

34) If two events are perfectly positively correlated, then

35) Many people do not fully insure against risk because

36) If fair insurance is offered to a risk-averse person, she will

38) Insurance companies do not cover losses that would

39) Risk-averse individuals make risky investments

42) Empirical evidence suggests that usury laws

44) Without usury laws, banks will

Answer: E(X) = (0 * .2) + (100 * .4) + (300 * .2) = $100

Answer: 0 < a < 1 implies risk averse.

Answer: See Figure 17.2

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