Microeconomics Tutorial Exercise #4 (Uncertainty and Consumer Behavior)

1. Suppose that Nicholes utility function is given by U(I) = income in thousands of dollars. a. Is Nichole risk loving, risk neutral, or risk averse? b. Suppose that Nichole is currently earning an income of $100,000 (I =100) and can earn that income next year with certainty. She is offered a chance to take a new job that offers a 0.6 probability of earning $120,000 and a 0.4 probability of earning $65,000. Should she take the new job? , where I represents annual

2. Suppose that 2 investments have the same three payoffs, but the probability associated with each payoff differs, as illustrated in the table below : Payoff Probability Investment A 0.1 0.8 0.1 Probability Investment B 0.3 0.4 0.3

$ 500 $ 1000 $ 1500

a). Find the expected return and standard deviation of each investment. b). Jack has the utility function U = 8 I. Which investment will he choose? c). Brad has the utility function U = 8 . Which investment will he choose? d). Jolie has the utility function U = 8 I. Which investment will she choose?

3. As the owner of a family farm whose wealth is $500,000, you must choose between sitting this season out and investing last years earnings ($300,000) in a safe money market fund playing 8.0 percent or planting summer corn. Planting costs $350,000, with a six-month time to harvest. If there is rain, planting summer corn will yield $700,000 in revenues at harvest. If there is a drought, planting will yield $200,000 in revenues.

As a third choice, you can purchase AgroLestari drought resistant summer corn at a cost of $400,000 that will yield $700,000 in revenues at harvest if there is rain, and $500,000 in revenues if there is a drought. You are risk averse, and your preference for family wealth (W) is specified by the relationship U(W)= . The probability of a summer drought is 0.3, while the probability of summer rain is 0.7

4. Jakarta is considering how much to spend to hire people to monitor parking violation. The following information is available to make decision. a. Hiring a person to monitor cost Rp 5.000.000 per month b. With one monitoring person hired, the probability of driver getting fine if they break parking rule is 0.25 c. With two monitor, the probability is 0.5, with three monitor 0.75, and with four it equal to 1. d. With two monitors hired, the current fine for breaking parking rule is Rp100.000 Questions: Assume that all driver are risk neutral. What parking fine would you levy and how many monitors would you hire to achieve the current level of deterrence against parking violation at the minimum cost. If drivers are highly risk aversy. How would you answer the first question?

5. A risk averse investor has 50% of her portfolio invested in stocks and 50% in government bond (Surat Utang Negara). Show how each of the following Answer Key 1. A). Nichole is risk averse person, because Nicholes marginal utility diminishes as income increases. (We can prove it by drawing the utility function curves) The standard deviation of the return on the stock market increases, but the expected return on the stock market remains the same. The expected return on the stock market increases, but the standard deviation of the stock market remains the same. The return on risk-free treasury bills increases.

B). U (I) =

. I=100, utility from get $100,000 of income

Expected return from new job = (0.6 x 120,000) + (0.4 x 65,000) = 98,000. Expected utility from new job = ( ) ( )

Nichole should not take the new job, because of her utility preferences is risk averse person. The expected utility from new job is smaller than the expected utility form current income.

2. A). Investment A Expected Return : 0.1 x 500 + 0.8 x 1000 + 0.1 x 1500 = 1000 Std Dev : ( : 223.60 ) ( ) ( )

Investment B Expected Return : 0.3 x 500 + 0.4 x 1000 + 0.3 x 1500 = 1000 Std Dev : ( : 387.29 With the same expected return, the standard deviation is differ between the 2 investment. Investment B is riskier than investment A, because the standard deviation is bigger. ) ( ) ( )

b). U = 8I Inv. A E(U) : 0.1 x 4000 + 0.8 x 8000 + 0.1 x 12000 = 8,000 Inv. B E(U) : 0.3 x 4000 + 0.4 x 8000 + 0.3 x 12000 = 8,000 Jack is indifferent between certain and uncertain event with the same expected return. Jack is risk neutral person.

c). U = 8 Inv. A E(U) : 0.1 x 178.89 + 0.8 x 252.98 + 0.1 x 309.84 = 251,26 Inv. B E(U) : 0.3 x 178.89 + 0.4 x 252.98 + 0.3 x 309.84 = 247.81 Brad will choose investment A, because the expected utility is bigger than investment B. Brad is risk averse person.

d). U = 8 I Inv. A E(U) : 0.1 x 2,000,000 + 0.8 x 8,000,000 + 0.1 x 18,000,000 = 8,400,000

Inv. B E(U) : 0.3 x 2,000,000 + 0.4 x 8,000,000 + 0.3 x 18,000,000 = 9,200,000 Jolie will choose investment B, because the expected utility is bigger than investment A. Jolie is risk loving person.

3. Investing E(U) : ( Planting regular summer corn E(U) : ( ( ( ( )) )) + = 822.85 ( )) = 907.74

Planting drought-resistant summer corn E(U) : ( ( ( ( )) )) + = 858.48

The biggest expected utility is INVESTING. 4. Risk Netral Jika semua pengendara merupakan risk netral maka, pengawas yang perlu digunakan adalah sebesar 2 orang saja dengan tingkat denda sebesar Rp 100.000. Hal ini disebabkan kemungkinan tingkat pelanggaran bagi seorang risk netral juga sama dengan tingkat kemungkinan semua pelanggar dapat ditangkap, yakni sebesar 50%. Risk averse Jika pengendara merupakan risk averse maka kemungkinan besar mereka takut untuk melakukan pelanggaran sehingga jumlah pengawas dapat diturunkan menjadi cukup sebesar 1 orang saja.

5. Standard deviation increase Expected return remains (saham) Bagi seorang risk averse, resiko harus diminimalisasi sebisa mungkin. Apabila resiko meningkat, tetapi return tetap tentu ia akan mengurangi proporsi sahamnya. Standard deviation remains Expected return increase (saham) Jika tingkat pengembalian meningkat dan resiko sama, maka ia akan menambah proporsi sahamnya. Expected return SUN increase Jika tingkat pengembalian sun meningkat dan resiko tetap (risk free), maka ia akan mengurangi proporsi sahamnya