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Econ 2020a / HBS 4010 / API-111

Problem Set 7 Solutions


Fall 2008

1. Stochastic Dominance and Lotteries

Classify each of the following pairs of lotteries into one of the following three
categories. Explain your reasoning in each case.

Category 1: Every consumer with (weakly) increasing utility function for money
would
prefer lottery 1 to lottery 2
Category 2: Every risk averse consumer with (weakly) increasing utility function for
money would prefer lottery 1 to lottery 2, but some consumers who are
not risk averse would prefer lottery 2.
Category 3: Some risk averse consumers would prefer lottery 1 to lottery 2, while
other
risk averse consumers would prefer lottery 2 to lottery 1

a) Lottery 1 has equal probabilities of the outcomes $100, $40, and $10. Lottery 2 has
a 0.3 probability of the outcome $80 and 0.7 probability of the outcome $0.

For each of the following answers, let F(x) denote the cumulative distribution for
Lottery 1 and G(x) denote the cumulative distribution for Lottery 2. As shown in the
following table, F(x) < G(x) for each x, which verifies that Lottery 1 FOSD Lottery 2
-- meaning that this pair of lotteries belongs in Category 1.

F(x) G(x)
0 < x < 10 0 0.7
10 < x < 40 1/3 0.7
40 < x < 80 2/3 0.7
80 < x < 100 2/3 1
x > 100 1 1

b) Lottery 1 has equal probabilities of the outcomes $ 75 and $ 25. Lottery 2 has an
0.25 probability of the outcome $100, an 0.5 probability of the outcome $50, and an
0.25 probability of the outcome $ 0.

Lottery 2 can be created by adding a mean-preserving spread to each of the outcomes


in Lottery 1 (+25 with probability 1/2 and -25 with probability 1/2). Therefore
Lottery 1 SOSD Lottery 2 -- meaning that this pair of lotteries belongs in Category 2.
c) Lottery 1 gives $50 with certainty. Lottery 2 has equal probabilities of the
outcomes $60 and $20.

Lottery 1 has expected value 50 and Lottery 2 has expected value 40. But the largest
value in Lottery 2 is larger than the largest value in Lottery 1 so Lottery 1 does not
FOSD Lottery 2. But Lottery 1 has a higher expected value and no risk, which
suggests the following comparison.

Consider a third lottery, Lottery 3, that gives $40 with certainty. Every consumer
with weakly increasing utility function would prefer Lottery 1 to Lottery 3. Further,
Lottery 2 is Lottery 3 plus a mean-preserving spread (+20 or -20 with equal
probability). So every risk averse consumer with increasing utility function would
prefer Lottery 3 to Lottery 2. By transitivity, every risk averse consumer would prefer
Lottery 1 to Lottery 2.

So this pair of lotteries belongs in Category 2.

d) Lottery 1 has equal probabilities of $70 and $30. Lottery 2 gives $80 with
probability 0.25 and $40 with probability 0.75.

These lotteries each have expected value $50, so SOSD is possible, but FOSD is not.
For SOSD, it must be that one lottery has more extreme highest and lowest values.
Here, however, the highest possible value is in Lottery 2, but the lowest possible value
is in Lottery 1. This means that neither lottery can be recreated by adding mean-
preserving spreads to the other, so neither SOSD's the other. This pair of lotteries
belongs in Category 3.

2. Stochastic Dominance and Retirement Savings

a) First, lets write out the expected utility. Our utility u( ) will be a function of final
wealth. Let x be the number of risky asset units purchased, leaving (w - px) as the
money put into the safe asset (which doesnt earn any interest). After a year, our
wealth is:
Total Wealth = (w - px) + rx, where r is stochastic (i.e. uncertain).

So, expected utility is:


EU = j * u(w px + rj x)

To maximize expected utility, we take the first derivative with respect to the choice
variable, x.

(EU)(x) = j * (rj p) * u(w px + rj x) [using the chain rule...]


We are supposed to show that the optimal x> 0, even for a risk averter, since the risky
asset has a higher expected payoff than the safe asset. To check this, we can plug =
0 into the first order condition above and make sure that the whole FOC > 0: this tells
us expected utility is increasing at x= 0, so the consumer should consume a positive
level of the risky asset. It simplifies to:

(EU)(x=0) = j * (rj p) * u(w )

u(w) is independent of r & , so we can pull it outside the summation:

(EU)(x=0) = u(w) * [ j * (rj p) ]


n

= By the laws of probability, we know that


i
= 1 (i.e. the sum of all
i 1

probabilities). So were left with:

(EU)(x=0) = u(w) * [ j rj p ]

Were told in the problem that j rj >p. Assuming that more money is good,
u(w) > 0. As I said in the previous problem, this is always a fair assumption with
money.
So the entire derivative is positive, when x= 0. This means x=0 cannot possibly
be a utility maximizing condition, because a positive first derivative indicates that
utility is increasing as x increases. Thus, we must increase the level of x above 0 to
find the optimal level of investment. See Example 6.C.2 in MWG for a similar proof,
in the continuous case.

b) Now, we have a slightly different expected utility function, in which we have to


sum over all the possible distribution of wealth. The problem describes buying assets
in advance, and paying for them afterwards out of the asset return. Given the nature
of the safe asset, this is equivalent to saying that all wealth not spent on the risky asset
is the safe asset. So, we have the following expected utility function:

EU= 1 * u(w px + r1 x) + 2 * u(w px + rj2x)

We are asked to show that the distribution of wealth under the non-stochastic
specification (a fixed wealth w), for a fixed level of x, second-order stochastically
dominates (SOSD) the stochastic wealth. This is equivalent to saying that, for all
concave u(w):
1 * u(w px + r1 x) + 2 * u(w px + rj2x) >
1 * u(w1 px + r1 x) + 2 * u(w2 px + rj2x)
In words, SOSD means that any risk averter gets higher expected utility from the
non-stochastic set-up.
How can we prove SOSD? The expressions on each side of the inequality are
identical except for the constant wealth term on the left-hand side (the top line above).
Looking at the first term in each line, the left-hand side u( ) has a larger overall value
w w1
than the right-hand side u( ), since :
1 * u(w px + r1 x) > 1 * u(w1 px + r1 x)

But we also know that for the second term in each line, the opposite is true since
w w2
:
2 * u(w px + r2 x) > 2 * u(w1 px + r2 x)

How can we be sure that overall, the non-stochastic wealth produces higher
expected utility? Now we rely on the fact that SOSD refers to risk-averse consumers.
Risk aversion requires u(w) < 0, so the marginal utility of money decreases as wealth
w2
increases [u(w) < 0]. So, the additional expected utility of the higher payoff ( )
with stochastic wealth is outweighed by the decreased expected utility of the lower
w1
payoff ( ) with stochastic wealth.
If stochastic wealth and the return on the risky asset were not correlated, then we
w2 w1
would not be able to make this assumption. If > , but r2 < r1, then it would not
be obvious whether 1 * u(w px + r1 x) is greater or less than 2 * u(w1 px + r2 x) .
This would unravel the argument presented above.

c) Conceptually, this result should be clear. Given that the consumer is risk averse,
we know he/she will prefer the SOSD lottery the non-stochastic wealth. Since the
addition of stochastic wealth adds additional uncertainty into the consumers choice, it
follows reasonably that this person will try to avoid this uncertainty somewhat by
reducing the share of wealth in the risky asset. Mathematically, it turns out to be more
complicated to prove.
Consider the optimal level of the risky asset in the case of non-stochastic wealth:
EU(x)= 1 * ( r1 p ) * u(w px + r1 x) + 2 * ( r2 p ) * u(w px + rj2x) = 0

And heres the FOC for the case of stochastic wealth:

EU(x)= 1 * ( r1 p ) * u(w1 px + r1 x) + 2 * ( r2 p ) * u(w2 px + rj2x) = 0


The first term in this derivative is negative, since r1<p. The second term is
positive. To satisfy the FOC, the selection of x must make these positive and negative
terms cancel out.
Let xN* be the optimal choice in the Non-stochastic case. How will, xS*, the
optimal choice in the stochastic case, compare? For the first term in each derivative,
w w1
the term u(-) will be larger in the stochastic case, since , and risk-averters
have decreasing marginal utility of money. Similarly, the term u(-) will be smaller in
the stochastic case for the second term. If we kept the same x as the optimal choice in
the non-stochastic case, then the overall FOC would now be negative because we
made the negative term larger/more negative, and the positive term smaller.
To remedy this imbalance, and restore the FOC = 0, we have to change x to make
the negative terms closer to zero and the positive terms bigger again. To do this, we
have to decrease x. Why? For the first term in the derivative, decreasing x makes w1
px + r1 x larger, since r1<p. Due to concavity of u( ), this makes u( ) smaller, and
gets the overall term closer to zero. For the second term, decreasing x makes w1 px
+ r2 x smaller, since r2>p. Due to concavity of u( ), this makes u( ) greater, and gets
the overall expression for this second term more highly positive. This gets the FOC
back to zero.
Thus, xS* < xN*.

d) It wouldnt change the results in b & c. Thankfully, you dont need to show this.
However, if you are really interested in seeing the n-dimensional case, let me know
that was the way the problem was assigned a few years ago, so I can send you the
even more complicated solution from that one!

3. Cobb-Douglas Production Function

Part I: Profit Maximization Problem (PMP)

(a) The firms profit maximization problem is


max f zp w z .
z1 ,z2 0

Plugging in the functional form for f z , we get

max z1 4 z 2 2 p w1z1 w 2 z2 .
1 1

z1 ,z 2 0

3 1
(b) FOCs:


z1 14 z1 4 z2 2 p w1 0


1 1

z2 12 z1 4 z2 2 p w 2 0
w
Solving for z 2 as a function of w1 and w 2 , we get z2 2z1 w12 . Plugging this
back into the FOCs, we get

z1 w, p
p4
6 2 2 , and
2 w1 w 2

4
p
z2 w, p 5 3 .
2 w1w 2

p3
(c)
q

w, p 1 2 4
f z w, p ,z w, p 2
2 w1w 2

p4 p4 p4 p4
(d) w, p p.qw, p z1w1 z 2 w 2 4
2 w1w2 2 2 6 w1w 2 2 2 5 w1w 2 2 2 6 w1w 2 2

w, p p3
(e) 4 qw, p
p 2 w1w 2 2
w, p p4
6 2 2 z1 w, p
w1 2 w1 w 2

w, p p4
5 3 z 2 w, p
w 2 2 w1w 2

Part II: Cost Minimization Problem (CMP)

(f) The firms cost minimization problem is


min w z subject to f z q ,
z1 , z2 0

or, rewritten,
min w1z1 w2 z2 subject to z 1 4 z 1 2 q .
z1 , z2 0 1 2

We can set up the Lagrangian,


L w1z1 w2 z2 z1 4 z2 2 q .
1 1

(g) FOCs:
L
w1 14 z1 4 z2 2 0
3 1

z1

L
w2 12 z1 4 z2 2 0
1 1

z2
L
z1 4 z2 2 q 0
1 1

w
Using the first two first-order conditions, we obtain z2 2z1 w12 , the same
relationship as in the PMP! We now have one additional first-order condition.
w
Plugging z2 2z1 w12 into the last FOC results in the two conditional factor
demands:
2

4 w 3

z1 w, q q 3 2 , and
2w1
1
2w1 3
z2 w, q q
4
3
.
w 2

1 2
3w1 3 w2 3

(h) c w, q w1z1 w,q w2 z2 w,q q


4
3
2
23

c w,q
2

4 w
3

(i) q 3 2 z1 w, q
w1 2w1

c w,q
1

4 2w1
3

q
3
z2 w,q
w1 w2

Part III: PMP and CMP

(j) max pq c(w, q) .


q 0

We plug in the cost function from (h) to get,


1 2
3w1 3 w2 3

max pq q
4
3
2
q 0 23
We differentiate with respect to q , set the result equal to zero, and solve for q ,
p3
q w, p , which is the same result as in (c) above.
16w1w2 2

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