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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 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.
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.
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).
To maximize expected utility, we take the first derivative with respect to the choice
variable, x.
(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.
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
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!
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
or, rewritten,
min w1z1 w2 z2 subject to z 1 4 z 1 2 q .
z1 , z2 0 1 2
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
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
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