Economic Rationality and Utility Questions

You work for a consulting firm whose primary objective is to help businesses improve their strategic operations. Your firm recently was hired by a newspaper company named Hoosier Media Inc. The client’s print newspaper circulation and subscriptions have declined, resulting in 30% lower revenues over the last five years
January 25, 2019

Economic Rationality and Utility Questions

CHAPTER 1: Discussion Questions and Problems

 

  1. Differentiate the following terms/concepts:

 

  • Prospect and probability distribution

 

  • Risk and uncertainty

 

  • Utility function and expected utility

 

  • Risk aversion, risk seeking, and risk neutrality

 

  1. 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?

 

  1. 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?

 

  1. An individual has the following utility function: u(w) = w.5 where w = wealth.

 

  1. 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)

 

  1. What is the certainty equivalent for prospect P2?

 

  1. Without doing any calculations, would the certainty equivalent for prospect P1 be larger or smaller? Why?

 

  1. 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.