Question 1

Expected utility theory assumes that individuals have utility functions over a composite consumption good.

Accepted Answer

A) True 
 B)False  False

Question 2

When tastes are risk loving, a person will always choose a gamble that is riskier over one that is less risky.

Accepted Answer

A) True 
 B)False  False

Question 3

The certainty equivalent is less than the expected value of a gamble when tastes are risk averse.

Accepted Answer

A) True 
 B)False  True

Question 4

Which of the following is true about a risk-averse individual facing a full menu of actuarily fair insurance contracts to choose from?

Accepted Answer

A) The individual will "over-insure" if consumption is more meaningful in the good state. 
B) The individual will "over-insure" if consumption is more meaningful in the bad state. 
C) The individual will fully insure when tastes are state-independent. 
D) (a) and (b) are true. 
E) (a) and (c) are true.
F)(b) and (c) are true.
G)All of the above.
H)None of the above. 
A) The individual will "over-insure" if consumption is more meaningful in the good state. 
B) The individual will "over-insure" if consumption is more meaningful in the bad state. 
C) The individual will fully insure when tastes are state-independent. 
D) (a) and (b) are true. 
E) (a) and (c) are true.
F)(b) and (c) are true.
G)All of the above.
H)None of the above.

Question 5

The risk premium is negative when tastes are risk averse.

Accepted Answer

A) True 
 B)False

Question 6

Expected utility functions have to be concave if they are to represent risk averse tastes.

Accepted Answer

A) True 
 B)False

Question 7

The certainty equivalent of a gamble is negative when tastes are risk loving.

Accepted Answer

A) True 
 B)False

Question 8

Suppose an investor with state-independent tastes is offered the choice between investment A and investment B.Investment A offers profit of $2,000 with probability 0.4, $4,000 with probability 0.2 and $6,000 with probability 0.4.Investment B offers profit of $2,000 with probability of 0.5 and $6,000 with probability 0.5.If the investor is risk averse, he will choose investment A.

Accepted Answer

A) True 
 B)False

Question 9

Which of the following can explain the choice to gamble in casinos?

Accepted Answer

A) Gamblers have risk loving tastes. 
B) Gamblers have risk-averse but state-dependent tastes. 
C) The casino is operating at a loss. 
D) (a) and (b) 
E) (a) and C
F)(b) and (c)
G)All of the above.
H)None of the above. 
A) Gamblers have risk loving tastes. 
B) Gamblers have risk-averse but state-dependent tastes. 
C) The casino is operating at a loss. 
D) (a) and (b) 
E) (a) and C
F)(b) and (c)
G)All of the above.
H)None of the above.

Question 10

Which of the following is true about an individual's choice of insurance assuming state-independent tastes?

Accepted Answer

A) Full insurance will be chosen from a full menu of actuarily fair insurance if tastes are risk averse. 
B) No insurance will be chosen if the menu of insurance contracts is actuarily unfair and tastes are risk averse. 
C) No insurance will be chosen if the menu of insurance contracts is actuarily unfair and tastes are risk-neutral. 
D) (a) and (b) are true. 
E) (a) and (c) are true.
F)(b) and (c) are true.
G)All of the above.
H)None of the above 
A) Full insurance will be chosen from a full menu of actuarily fair insurance if tastes are risk averse. 
B) No insurance will be chosen if the menu of insurance contracts is actuarily unfair and tastes are risk averse. 
C) No insurance will be chosen if the menu of insurance contracts is actuarily unfair and tastes are risk-neutral. 
D) (a) and (b) are true. 
E) (a) and (c) are true.
F)(b) and (c) are true.
G)All of the above.
H)None of the above

Question 11

Suppose you and I are the only two individuals in the world and we both face individual risk in the following way: I get more consumption in state 1 than in state 2 while you get more consumption in state 2 than in state 1.
a.Suppose we are both risk averse and our tastes are state-independent.Will we fully insure one another in a competitive equilibrium?
b.How does your answer change if there is aggregate risk in the sense that overall consumption is higher in state 2 than in state 1?
c.Is it possible that we insure each other if our tastes are risk neutral and state-independent? If so, are the terms actuarily fair?
d.Suppose that there is no aggregate risk but our tastes are state-dependent.How might we fully insure each other if our beliefs about the probability of each state differ?

Accepted Answer

a. Yes. (See panel (a) of Graph 17.10 in

Question 12

Suppose that individuals with state-independent and risk-averse tastes insure each other through state-contingent trades.If there is no aggregate risk, the competitive equilibrium price will then result in actuarily fair insurance terms.

Accepted Answer

A) True 
 B)False

Question 13

Suppose that you face a gamble that has a payoff of $1000 with probability 0.2 and a payoff of $200 with probability 0.8.I approach you to sell you insurance with a premium of p and a benefit of

Accepted Answer

A) p=8, b=10 
B) p=400, b=500 
C) p=720, b=900 
D) (a) and (b) are actuarily fair 
E) (a) and (c) are actuarily fair
F)(b) and (c) are actuarily fair
G)All of the above.
H)None of the above. 
A) p=8, b=10 
B) p=400, b=500 
C) p=720, b=900 
D) (a) and (b) are actuarily fair 
E) (a) and (c) are actuarily fair
F)(b) and (c) are actuarily fair
G)All of the above.
H)None of the above.

Question 14

Suppose you rent an apartment and are worried about a break-in that results in theft of your property.Suppose your monthly consumption level is currently $4,000 but a break-in would result in you having to finance your purchase of replacement property -- and this would reduce your current consumption to $2,000 per month.There is a 10% chance of a break-in, and your tastes can be modeled with the expected utility form using the function   . 
a.What is the utility of the expected value of the gamble you face, and what is the expected utility of the gamble?
b.How does your answer to (a) change if the probability of a break-in increases to 20%?
c.What is the certainty equivalent and the risk premium in each case?
d.What equation would you have to solve to get the answer to the following: How much would you be willing to pay to keep the crime rate in your area from increasing (i.e.to keep the probability of a break in to 10% rather than have it rise to 20%) assuming there is no rental insurance available in your area?
e.What would you be willing to pay to avoid the increase in the crime rate if there is a full menu of actuarily fair rental insurance available at all times?

Accepted Answer

a. The expected value of the gamble is 3

Question 15

Actuarily fair insurance reduces risk without changing the expected value of a gamble.

Accepted Answer

A) True 
 B)False

Question 16

Suppose you rent an apartment and are worried about a break-in that results in theft of your property.Suppose your monthly consumption level is currently $4,000 but a break-in would result in you having to finance your purchase of replacement property -- and this would reduce your current consumption to $2,000 per month.There is a 10% chance of a break-in.
a.On a graph with "consumption" on the horizontal and "utility" on the vertical axis, illustrate a utility/consumption relationship that is consistent with risk averse tastes.
b.On your graph, illustrate the utility in the "good" state, the utility in the "bad" state and the expected utility of facing the gamble.
c.Which of these changes when the probability of a break-in increases to 20%?
d.A renter's insurance policy consists of a premium p and a benefit level b.What is (b,p) for full, actuarily fair insurance before and after the increase in risk?
e.True or False: You are more likely to buy actuarily fair full insurance after the increase in risk than before.

Accepted Answer

a. This is illustrated by the concave cu

Question 17

Suppose an individual has state-independent tastes and invests in risky stocks rather than safe bonds.We can infer that he must be risk loving.

Accepted Answer

A) True 
 B)False

Question 18

Risk averse individuals will fully insure to avoid risk.

Accepted Answer

A) True 
 B)False

Question 19

If the probability of the bad outcome is 0.5, the benefit level of actuarily fair insurance will be half the premium.

Accepted Answer

A) True 
 B)False

Question 20

The independence axiom implies that if I prefer a bottle of wine over a six pack of beer I will prefer half a bottle of wine with a bag of pretzels over half a sixpack of beer with a bag of pretzels.

Accepted Answer

A) True 
 B)False

Exam 17: Choice and Markets in the Presence of Risk

Expected utility theory assumes that individuals have utility functions over a composite consumption good.

When tastes are risk loving, a person will always choose a gamble that is riskier over one that is less risky.

The certainty equivalent is less than the expected value of a gamble when tastes are risk averse.

Which of the following is true about a risk-averse individual facing a full menu of actuarily fair insurance contracts to choose from?

The risk premium is negative when tastes are risk averse.

Expected utility functions have to be concave if they are to represent risk averse tastes.

The certainty equivalent of a gamble is negative when tastes are risk loving.

Which of the following can explain the choice to gamble in casinos?

Which of the following is true about an individual's choice of insurance assuming state-independent tastes?

Suppose that individuals with state-independent and risk-averse tastes insure each other through state-contingent trades.If there is no aggregate risk, the competitive equilibrium price will then result in actuarily fair insurance terms.

Suppose that you face a gamble that has a payoff of $1000 with probability 0.2 and a payoff of $200 with probability 0.8.I approach you to sell you insurance with a premium of p and a benefit of

Actuarily fair insurance reduces risk without changing the expected value of a gamble.

Suppose an individual has state-independent tastes and invests in risky stocks rather than safe bonds.We can infer that he must be risk loving.

Risk averse individuals will fully insure to avoid risk.

If the probability of the bad outcome is 0.5, the benefit level of actuarily fair insurance will be half the premium.

The independence axiom implies that if I prefer a bottle of wine over a six pack of beer I will prefer half a bottle of wine with a bag of pretzels over half a sixpack of beer with a bag of pretzels.

Introduction

A Consumers Economic Circumstances

Economic Circumstances in Labor and Financial Markets

Tastes and Indifference Curves

Different Types of Tastes

Doing the Best We Can

Income and Substitution Effects in Consumer Goods Markets

Wealth and Substitution Effects in Labor and Capital Markets

Demand for Goods and Supply of Labor and Capital

Consumer Surplus and Deadweight Loss

One Input and One Output: a Short-Run Producer Model

Production With Multiple Inputs

Production Decisions in the Short and Long Run

Competitive Market Equilibrium

The Invisible Hand and the First Welfare Theorem

General Equilibrium

Elasticities, Price-Distorting Policies, and Non-Price Rationing

Distortionary Taxes and Subsidies

Prices and Distortions Across Markets

Externalities in Competitive Markets

Asymmetric Information in Competitive Markets

Monopoly

Strategic Thinking and Game Theory

Oligopoly

Product Differentiation and Innovation in Markets

Public Goods

Governments and Politics

What Is Good Challenges From Psychology and Philosophy

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