EC3000 Advanced Microeconomics 2023-24

Seminar 2: Problem Set

Module leader: Guillaume Wilemme - [email protected]
Seminar Tutor: Mert Gumren - [email protected]
Seminars play a pivotal role in assimilating the content presented in lectures and in
achieving optimal readiness for both the midterm and final exams. Engaging in seminars
encompasses three essential actions for students:

• Preparing the problem set in the week before the seminar.

• Actively participating during the seminar sessions,

• Reviewing and repeating the seminars’ questions and exercises.

Each seminar is structured around a problem set that comprises short-essay questions,
requiring minimal mathematical manipulation, as well as numerical exercises. These
questions and exercises closely mirror the difficulty and subject matter of the midterm
and final exams. Questions marked with the symbol ♠ signify tasks that students may
choose to prioritise. Students are invited to think about the takeaway or morale of each
question and exercise.

Questions
Question 1. ♠ Steve has a lottery ticket that gives him £100 with probability 0.1. A
company proposes to buy his ticket for £6. Steve’s preferences are such that his risk
premium is £3. What is the certainty equivalent of this lottery ticket for Steve? You will
also explain carefully the concepts of certainty equivalent and risk premium. Does Steve
sell his ticket for £6? Why?

Question 2. Many celebrities buy insurance for particular parts of their body. Singers
insure vocal chords, athletes insure arms or legs. Rumors say Heidi Klum has insured
her legs for $2 million each, Daniel Craig has insured his full body for $9.5 million and
Jennifer Lopez has insured her bottom for $27 million. Real Madrid insured Cristiano
Ronaldo’s legs for $144 million.
How can we make sense of these numbers? Use a maximum of 200 words.

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Question 3. In the theory we use, individual attitudes towards risk is a matter of pref-
erences. The theory can tell the best choice for an individual given their utility function.
What about groups of individuals? What should be the best choice under uncertainty for
a government? Arrow and Lind use the risk-spreading result to answer that question.

Arrow and Lind (1970) write:1

‘...when the risks associated with a public investment are publicly borne, the
total cost of risk-bearing is insignificant and, therefore, the government should
ignore uncertainty in evaluating public investments...This result is obtained
not because the government is able to pool investments but because the govern-
ment distributes the risk associated with any investment among a large number
of people. It is the risk-spreading aspect of government investment that is es-
sential to this result.’

Explain carefully the point of Arrow and Lind. Why can government ‘ignore uncertainty’ ?
Your answer must contain less than 200 words.

Question 4. ♠ ‘Don’t put all your eggs in one basket.’ We could add at the end of the
sentence: ‘...even if it is the most solid basket you have.’
Comment this maxim in the light of portfolio diversification theory, using a maximum of
200 words.

Exercises

Exercise 1 (Risk spreading). ♠ This exercise illustrates risk spreading through an

example.

Daniel has an asset that yields X = £200 with probability 3/4 and X = £100 with
probability 1/4. His preferences are such that the certainty equivalent of this asset for
him is £168.

1. Why is Daniel risk-averse?

2. What is the maximum price a risk-neutral individual would pay to buy this asset?
Can Daniel pass a deal with a risk-neutral individual?

3. Daniel asks Ashley if she is interested in buying the asset. Ashley’s preferences are
captured by the utility function u(x) = (x + 100)1/4 . Show that Ashley would pay
at most £165 to buy this asset. Can Daniel sell his asset to Ashley?
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Arrow and Lind. ‘Uncertainty and the Evaluation of Public Investment Decisions.’ American Eco-
nomic Review, 1970.

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 4. Ashley has a twin sister, Mary-Kate, who has the same preferences over risk. Daniel
considers selling half of the asset, namely Y ≡ X/2, to each one. Show that Ashley
and Mary-Kate would each pay at most £85 to buy half of the asset.

5. Conclude and explain the gains from risk spreading.

Exercise 2 (Risk pooling with correlated risks). This exercise provides an example
of risk pooling with the risks can be negatively or positively correlated.

A winegrower has a vineyard in region A. It regularly happens that a bad weather

entirely destroys a vineyard. Denote XA the economic loss when the vineyard is de-
stroyed. XA = −100 when the vineyard is destroyed, and XA = 0 otherwise. Another
winegrower, with a vineyard in region B has the same problem with the same economic
risk: XB = −100 when the vineyard is destroyed, and XB = 0 otherwise.
Depending on the geographical proximity between the two regions, the risks can be
correlated or not. The probabilities of each possible state is given by the following table:

XA = 0 XA = −100
1+α 1−α
XB = 0 4 4
1−α 1+α
XB = −100 4 4

where −1 ≤ α ≤ 1. For instance, the probability that the weather is catastrophic in

region A and B at the same time is 1+α
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(bottom-right). Denote u(x) the utility function
of each winegrower.

1. What happens when α = 1, 0 and −1? Explain what α captures.

2. What are the expectations of these variables, E[XA ] and E[XB ]? What is the ex-
pected utility of each winegrower in autarky, E[u(XA )] and E[u(XB )]?

3. Suppose they decide to pool risks together. Denote Y = XA +XB

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. Do you think Y is
more or less risky than XA (or XB )?

4. What is the expected utility of each winegrower when they pool risks, E[u(Y )] as a
function of α?

5. Comment on the gains from pooling risks when α takes the value 1, 0 and -1.

Exercise 3 (Portfolio diversification). ♠ This exercise makes you prove the diversi-
fication result in an example.

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 Elliot has preferences that are captured by the utility function U (ω) = ω 2/3 . He has
to choose whether to invest his entire wealth in an asset and can choose between asset X
which pays £100 with a 70% chance and £0 with a 30% chance, or asset Y which pays
£100 with a probability of 40% and £0 with 60% probability. These assets have the same
price and are uncorrelated. We will round numbers at the second digit.

1. Without computing expected utilities, explain why Elliot strictly prefers asset X
over Y .

2. Show that Elliot is risk averse.

3. Compute the expected utility of each asset E[U (X)] and E[U (Y )].
Consider the returns Z(λ) of a portfolio that contains a share 1 − λ of X and a
share λ of Y .

4. Show the four possible outcomes of the portfolio as a function of λ and the corre-
sponding probabilities.

5. What is the expected utility of the portfolio as a function of λ?

6. Compute the expected utility of the portfolio for the values λ = 0, 0.03, 0.06 and 1.
Conclude.