CHAPTER 1: Discussion Questions and Problems
- Differentiate the following terms/concepts:
- Prospect and probability distribution
- Utility function and expected utility
- Risk aversion, risk seeking, and risk neutrality
- When eating out, Rory prefers spaghetti over a hamburger. Last night she had a choice of spaghetti and macaroni and cheese and decided on the spaghetti again. The night before, Rory had a choice between spaghetti, pizza, and a hamburger and this time she had pizza. Then, today she chose macaroni and cheese over a hamburger. Does her selection today indicate that Rory’s choices are consistent with economic rationality? Why or why not?
- Consider a person with the following utility function over wealth: u(w) = ew, where e is the exponential function (approximately equal to 2.7183) and w = wealth in hundreds of thousands of dollars. Suppose that this person has a 40% chance of wealth of $50,000 and a 60% chance of wealth of $1,000,000 as summarized by P(0.40, $50,000, $1,000,000).
- What is the expected value of wealth?
- Construct a graph of this utility function.
The function is convex.
- Is this person risk averse, risk neutral, or a risk seeker?
- What is this person’s certainty equivalent for the prospect?
- An individual has the following utility function: u(w) = w.5 where w = wealth.
- Using expected utility, order the following prospects in terms of preference, from the most to the least preferred:
P1(.8, 1,000, 600)
P2(.7, 1,200, 600)
P3(.5, 2,000, 300)
- What is the certainty equivalent for prospect P2?
- Without doing any calculations, would the certainty equivalent for prospect P1 be larger or smaller? Why?
- Consider two prospects:
Problem 1: Choose between
Prospect A: $2,500 with probability .33,
$2,400 with probability .66,
Zero with probability .01.
And Prospect B: $2,400 with certainty.
Problem 2: Choose between
Prospect C: $2,500 with probability .33,
Zero with probability .67.
And Prospect D: $2,400 with probability .34,
Zero with probability .66.
It has been shown by Daniel Kahneman and Amos Tversky (1979, “Prospect theory: An analysis of decision under risk,” Econometrica 47(2), 263-291) that more people choose B when presented with problem 1 and when presented with problem 2, most people choose C. These choices violate expected utility theory. Why?
Discussion question 1
Explain in little words what we mean by neoclassical economics or the rational self-interest model.
Discussion question 2
The “the blockheads argument” is an argument which attempts to justify the rationality assumption of the neoclassical mode. Outline the blockheads argument.
Discussion question 3
Some people claim that the widespread belief in the neoclassical model was responsible, at least in part, for the financial crisis of 2008. Discuss.