EC421 – Advanced Microeconomics
Tutorial 1 – Sample Solutions
True/False Questions: Provide a brief explanation for your answer.
1. In the model of insurance and uncertainty discussed during lectures, an individual exhibits
declining marginal utility of income if and only if she is risk averse.
TRUE. Under this simple model, the shape of the income-utility curve determines
one’s taste for risk. If the individual exhibits declining marginal
utility of income, her income-utility curve will be concave, and she will be
risk averse.
A graph may be used to illustrate this concept. Additionally, students could use an
example for utility functions - for example, one for a risk averse and one for a risk
loving individuals and take the first derivative to show that marginal utility only
declines for risk averse people.
2. A health insurance contract with a premium of r = £200, a pay-out q = £800 offers partial
and fair insurance if IH = £1,500, IS = £0, and the probability of illness p = 0.2.
FALSE. While the insurance contract is indeed partial because income in the healthy
state (£1,500 - £200 = £1,300) is larger than income in the sick state (£0 - £200 + £800 =
£600), this is not a fair contract. In fair contracts, the premium equals the probability of
illness times the payout (r = p*q). In this example, this is not the case (£200 > 0.2*£800).
Holding everything else constant, for this to be a fair contract, the probability of illness
would need to be p = 0.25 since £200 = 0.25*£800. Thus, this contract offers partial and
unfair insurance.
3. Suppose you have a job paying £50,000 per year. There is a five percent probability that
your wage is reduced to £20,000 next year. Assuming you could insure yourself against the
risk of reduced income next year, the actuarially fair insurance premium would equal £1,000.
FALSE. The actuarially fair insurance premium would be 0.05*£30,000 = £1,500
(probability of adverse event times costs of adverse event). £20,000 is the new wage after
the “bad event”, not the actual cost of the event.
4. Insurance represents a transfer of wealth from healthy states to sick states.
TRUE. The nature of the insurance contract is that the individual loses income
in the healthy state and gains income in the sick state relative to the
state of no insurance. The risk-averse individual willingly sacrifices some
good times in the healthy state to ease the bad times in the sick state. This is called
consumption smoothing.
Short Answer Questions:
5. Discuss how the concepts of issues related to asymmetric information can be applied to
financial markets.
Adverse selection and moral hazard are serious problems in financial markets. When
firms sell stocks and bonds, they know much more about their true financial condition
than do potential investors. Investors are reluctant to buy stocks and bonds issued by
small and medium-sized firms because they lack sufficient information about these
firms. This can lead to adverse selection.
Investors also worry about the moral hazard problem of firms misusing the funds they
raise through the sale of stocks and bonds. Agencies like the Securities and Exchange
Commission (SEC) have the authority to regulate the stock and bond markets and
attempts to reduce adverse selection and moral hazard problems. The failure of
financial firms and the financial frauds of the late 2000s indicate that information
problems persist in financial markets.
Some examples:
Sale of a financial product (e.g., a mortgage) knowing that it is not in the clients’
interests to buy it.
Paying myself excessive bonuses out of funds that I am managing on a client’s
behalf.
Taking (unnecessary) risks that the client then must bear.
6. In the paper “Asymmetric Information, Adverse Selection and Online Disclosure: The
Case of eBay Motors” from the suggested readings, Gregory Lewis (2011) discusses adverse
selection in online markets.
a) Why might adverse selection occur in the first place in online markets?
In online markets, buyers do not get to physically see the good, which could lead to
adverse selection if sellers try to exploit their private information.
b) Discuss two possible (policy) solutions that might limit the negative effects that occur
because of adverse selection in online markets?
- Money back guarantee (accountability for inferior products)
- Reviews
- Money only paid once product arrives and is as advertised
- Certificates
- More transparency through photos and videos
c) What are the authors’ conclusions regarding the presence of adverse selection in the
online car market? What is the authors’ explanation for this?
The author concludes that the reason for adverse selection being quite limited in the
online car market is the fact that disclosure and transparency mechanisms are in place
and are working.
Analytical Problems:
7. You are faced with two job opportunities. The actual monthly salary is uncertain, but you
have the following information:
- Job 1: 40% chance of £2,500, 60% of £1,600
- Job 2: 25% chance of $5,000, 75% of £1,000
a) Which job is preferred if you have the following utility functions, where x represents
monthly salary? Show your work.
i) U(x) = x1/2
ii) U(x) = x2
To determine which job is preferred, we need to find the expected utilities for the two
jobs under each utility function.
i) U(x) = x1/2
Job 1: 0.4 (2,500)1/2 + 0.6 (1,600)1/2 = 20 + 24 = 44
Job 2: 0.25 (5,000)1/2 + 0.75 (1,000)1/2 = 17.68 + 23.72 = 41.4
With this utility function, the risk averse individual will prefer job 1.
ii) U(x) = x2
Job 1: 0.4 (2,500)2 + 0.6 (1,600)2 = 2,500,000 + 1,536,000 = 4,036,000
Job 2: 0.25 (5,000)2 + 0.75 (1,000)2 = 6,250,000 + 1,000,000 = 7,250,000
With this utility function, the risk loving individual will prefer job 2.
b) Using the concept of expected value (in this case expected income), discuss why parts of
your answer to part a) appear strange. In your answer, explain the reasoning for this.
When calculating the expected income for the two jobs, we get:
EI (Job 1) = 0.4 (£2,500) + 0.6 (£1,600) = £1,960
EI (Job 2) = 0.25 (£2,500) + 0.75 (£1,000) = £2,000
This shows that, based on the probabilities for the various salaries, job 2 has a higher
expected income than job 1. Despite this, our answer to part a) shows that the risk
averse individual will prefer job 1 to job 2. The reason for this is that risk averse
individuals have a strong preference for minimising exposure to risk. The fact that the
“worst case” salary for job 1 is higher than for job 2 influence the risk averse
individuals’ preference.
8. Moe, Larry and Joe each have £12 to spend on beer in a bar. Their utility functions are U
(BM) = √ B M, U (BL) = BL, and U (BJ) = (BJ)2, respectively, where B denotes the consumption
of beer bottles in the bar. The price of a bottle of beer is £3. Unfortunately, the only bar is in a
dangerous part of town and there is a 50% chance that they will get mugged on their way to
the bar. If that happens, they lose their entire bar money.
Use the information above to answer the following questions.
a) Find the expected value for each of them (here: expected consumption of beer bottles).
For all of them: EV = 0.5*(4 bottles) + 0.5*(0 bottles) = 2 bottles
b) Find the expected utility of consuming beer for each of them.
Moe: EU = 0.5*U(4 bottles) + 0.5*U(0 bottles) = 0.5*√ 4 + 0.5*√ 0 = 1
Larry: EU = 0.5*U(4 bottles) + 0.5*U(0 bottles) = 0.5*4 + 0.5*0 = 2
Joe: EU = 0.5*U(4 bottles) + 0.5*U(0 bottles) = 0.5*(4)2 + 0.5*(0)2 = 8
c) Now assume that they can each buy “protection” from the neighbourhood bad guy at £6.
each. If they buy this protection, they will not get mugged. Which of the friends will buy the
protection?
If they buy the “protection”, each of them will only have £6 left to spend on beer. Thus,
they will only be able to afford to buy two bottles. There will however be no uncertainty
anymore.
Moe: EU (with protection) = U(2) = √ 2 = 1.41 Moe will buy protection since 1.41 > 1
Larry: EU (with protection) = U(2) = 2 Larry is indifferent between buying
protection and walking to the bar without protection
Joe: EU (with protection) = U(2) = (2)2 = 4 Joe will not buy protection since 4 < 8.
d) Discuss the findings from part c) in the light of our lecture content.
[Hint: For a good answer, try to include the terms risk attitudes, asymmetric information, and
insurance in your response.
As discussed during lectures, risk averse individuals prefer a certain outcome to an
uncertain outcome and they are willing to pay for this. In this example, we can see that
Moe is risk averse with a utility function of U (BM) = √ B M , and we find that he receives
greater utility from buying the protection against the bad event. On the other hand, Joe
is risk loving with a utility function of U (BJ) = (BJ)2, and we find that he will prefer
going without buying the protection. This is consistent with the fact that for risk loving
individuals, the expected utility (EU) is greater than the utility of the expected value
(UEV) when there is uncertainty like in this problem.
In this example, buying protection from the neighbourhood bad guy is equivalent to
buying full insurance because individuals will experience the same level of utility in the
good state (no mugging) or the bad state (mugging). Thus, buying protection is an
example of (full) consumption smoothing since it allows individuals to always have the
same level of consumption and removes the asymmetric/incomplete information in the
form of not knowing whether one gets mugged or not.
Similar to our class discussion on insurance for health and cars, individuals need to pay
for premiums. In this example, the premium for ‘full insurance’ is £6. Students could
also show that this is the fair premium using the formula used in class lectures (r = PL *
q). In this example, q is equal to £12 since the individuals lose all their income if they get
mugged and PL is equal to 0.5. Thus, the fair premium is £12 * 0.5 = £6.
9. Malcom’s preferences over wealth can be described by the utility function U(x) = √ x .
Suppose that his entire wealth is provided by a property worth £1 million. However, this
property has a 10% chance of being completely destroyed by a fire.
(a) Compute the expected utility of the property for Malcom.
EU = 0.9 * U(1,000,000) + 0.1 * U(0) = 0.9 * √ 1 ,000 , 000 + 0.1 * √ 0 = 900
(b) Suppose that a fire insurance contract is available that offers full coverage for Malcom’s
property in case of accident. For each of the following two scenarios, determine whether
Malcom will buy insurance and explain your answer:
i. the price of insurance is £200,000?
EU (with insurance) = √ 1,000,000−200,000 = √ 800,000 = 894.43
He will not buy insurance at this price since his expected utility with insurance is
smaller than his expected utility without insurance (from part a: 900).
ii. the price of insurance is £150,000?
EU (with insurance) = √ 1,000,000−150,000 = √ 850,000 = 921.45
He will buy insurance at this price since his expected utility with insurance is greater
than his expected utility without insurance (from part a: 900).
(c) What is the Certainty Equivalent for Malcom? Based on your answer, up to how much
would Malcom be willing to spend on the insurance contract? Explain your response.
The certainty equivalent represents the remaining wealth after paying the insurance
premium where Malcom would be indifferent between not having insurance and buying
insurance. Thus, his expected utility of buying insurance needs to be equal to 900, his
expected utility without insurance.
√ CE = 900
CE = £810,000
Thus, Malcom would be willing to spend £190,000 for insurance.
10. All entry-level accountants in Glasgow either have high or low abilities. All potential
employers value a high-ability worker at £8,000 per month and a low-ability worker at
£4,000. The supply of high-ability workers is QS (High) = 0.05 (W - 2,000) and the supply for
low-ability workers is QS (Low) = 0.1 (W - 2,000), where W is the monthly wage.
Use the information above to answer the following questions:
a) If employers are not able to observe the workers’ abilities and employers assume that 1/4
of the entry accountants are high-quality, what is the equilibrium wage? How many
workers of each type do employers hire? Show your work.
The expected value of a job applicant to an employer is 1/4 (£8,000) + 3/4 (£4,000) =
£5,000. Thus, the equilibrium wage is £5,000. Using the supply equations, we can find
the total number of workers of each type that are hired.
QS (High) = 0.05 (W - 2,000) = 0.05 (5,000 - 2,000) = 150
QS (Low) = 0.1 (W - 2,000) = 0.1 (5,000 - 2,000) = 300
Employers will hire 150 high-ability accountants and 300 low-ability accountants.
b) Now let’s assume that employers are able to observe the workers’ abilities. What are the
equilibrium wages in this case? How many workers of each type do employers hire?
Show your work.
When workers’ abilities are observable, the wage for high-ability workers must equal
£8,000, their value to employers. Similarly, the wage of low-ability workers should be
£4,000. Using the supply equations, we can find the number of workers of each type that
are hired.
QS (High) = 0.05 (W - 2,000) = 0.05 (8,000 - 2,000) = 300
QS (Low) = 0.1 (W - 2,000) = 0.1 (4,000 - 2,000) = 200
Employers will hire 300 high-ability accountants and 200 low-ability accountants.
c) Using your answers to parts a) and b), comment on the role of asymmetric information in
the labour market. In your answer, discuss possible solutions to the issue at hand.
The results in part b) implies that ideally employers would hire 300 high-ability workers
and 200 low-ability workers. This is the socially optimum outcome in this labour
market. As a result of asymmetric information regarding the workers’ abilities in the
scenario described in part a), employers end up hiring too few high-ability accountants
(150 instead of 300) and too many low-ability workers (300 instead of 200). This leads to
an inefficient outcome where employers will not be able to be as productive as they
could be and there will be a deadweight loss.
A possible solution to the issue will be for employers to ask workers to complete certain
exercises and activities during the interview process to allow them to better screen their
abilities. Alternatively, employers could hire workers to temporary 2-month contracts
at the start. At the end of that period, the workers’ performances will be evaluated and
a decision will be based whether they will be hired on a permanent basis. This will
reduce the information gap between employers and workers.
