Question 1

Why do we say that the utility theory has ordinal utility?

Accepted Answer

Utility theory is considered to have ordinal utility because it focuses on the ranking or ordering of preferences and choices rather than quantifying the absolute level of satisfaction or utility. It is concerned with how options are relatively valued or preferred over others, not with measuring the exact level of satisfaction derived from those options.

Question 2

Identify the utility that can represent the absolute level of satisfaction.

Accepted Answer

Cardinal utility represents the absolute level of satisfaction, as it assigns specific numerical values to levels of satisfaction or utility, allowing for a precise measurement of utility differences.

Question 3

Identify the probability that is based on a person's beliefs and experiences, and belongs to the realm of behavioral economics rather than traditional rationality-based economics.

Accepted Answer

Subjective probability is based on a person's beliefs, experiences, or intuition rather than on objective data or precise calculation. It is often used in behavioral economics to understand how individuals make decisions under uncertainty, reflecting personal judgments or opinions about the likelihood of uncertain events.

Question 4

According to the utility theory, a glass of milk mixed with Milo (Nestlè's drink mix), will be preferred to milk or Milo alone.Identify this assumption on preference.

Accepted Answer

The assumption that a mixture of milk and Milo is preferred over either component alone is an example of the convexity assumption in utility theory. Convexity implies that combinations or mixtures of goods can provide higher utility than extreme amounts of either good alone, reflecting a preference for diversity or balance.

Question 5

Identify the utility function of a risk seeking individual.

Accepted Answer

A risk seeking individual would have a utility function that increases with wealth, indicating that they are willing to take on more risk for the potential of higher returns. The function U(W) = W represents a linear utility function, where the individual values each unit of wealth equally. Therefore, the best choice for a risk seeking individual would be to choose the option that offers the highest potential return, even if it comes with a higher level of risk.

Question 6

According to the utility theory, if one week of food is preferred to one week of clothing, then two weeks of food is a preferred package to one week of food.Identify this assumption on preference.

Accepted Answer

Monotonicity in utility theory implies that more of a good is always preferred to less, assuming all else remains equal. This assumption is reflected in the statement that two weeks of food is preferred over one week, indicating a preference for a larger quantity of the good.

Question 7

In the utility function of a risk-averse individual, the utility is always increasing although at a decreasing rate.Identify the feature of this utility function.

Accepted Answer

Diminishing marginal utility is the correct feature because it describes a situation where, as consumption increases, the additional satisfaction (utility) gained from consuming one more unit decreases. This is consistent with the description of a risk-averse individual's utility function increasing at a decreasing rate.

Question 8

Daniel Bernoulli was the first one to provide a solution to the St.Petersburg paradox in the eighteenth century.Identify this solution.

Accepted Answer

Daniel Bernoulli's solution to the St. Petersburg paradox suggested that individuals base their decisions not on the expected monetary value of a lottery, but on the expected utility derived from the wealth, which accounts for diminishing marginal utility of wealth.

Question 9

Unregulated companies are found to hedge more than regulated ones.

Accepted Answer

Regulated companies often hedge more than unregulated ones because they have more predictable cash flows and a greater need to meet financial targets and regulatory requirements.

Question 10

An individual's preference is characterized by the diminishing marginal utility function.Identify the risk attitude of this individual.

Accepted Answer

An individual characterized by a diminishing marginal utility function is typically risk averse. This is because as the individual gains more of a good, the additional satisfaction (utility) gained from consuming an extra unit of the good decreases, leading them to prefer certain outcomes over uncertain ones with the same expected value.

Question 11

An individual's preference is characterized by the increasing marginal utility function.Identify the risk attitude of this individual.

Accepted Answer

An increasing marginal utility function indicates that the individual derives more satisfaction from each additional unit of consumption, which is characteristic of a risk-seeking attitude. This is because they value potential gains more highly, even if those gains come with higher risks.

Question 12

Identify the coding of alternatives that makes individuals vary from E(U) maximizing behavior.

Accepted Answer

Framing effect refers to the way information is presented, which can influence decision-making and lead individuals away from expected utility (E(U)) maximizing behavior.

Question 13

Identify the utility function of a risk averse individual.

Accepted Answer

The utility function of a risk-averse individual is typically concave, indicating that they derive less utility from each additional unit of wealth. The given choice A, despite its unconventional notation, suggests a non-linear relationship with wealth, which aligns with risk aversion. Other options either represent linear relationships (indicating risk neutrality) or an inverse relationship with wealth, which does not accurately reflect risk aversion.

Question 14

In a football tournament, if University of Florida beats Ohio State, and Ohio State beats Georgia Tech, it does not mean that Florida beats Georgia Tech.This scenario violates the rationality assumption on preference of the utility theory.Identify this assumption of preference.

Accepted Answer

The assumption violated is the transitivity of preference, which states that if a person prefers option A over B and prefers B over C, then they should prefer A over C. In the given scenario, this logical sequence does not hold, indicating a violation of transitivity.

Question 15

Identify the utility function of a risk seeking individual.

Accepted Answer

A risk-seeking individual has a utility function that is convex, indicating increasing marginal utility with wealth. U(W) = W^2 is convex, representing risk-seeking behavior.

Question 16

The preferences a risk neutral individual can be captured in E(U) theory by:

Accepted Answer

A risk-neutral individual is indifferent to risk and values outcomes solely based on their expected values, which is represented by a linear utility function. This means their utility increases directly in proportion to the increase in wealth, without showing any preference for or aversion to risk.

Question 17

While utility theory deals with situations in which there is no uncertainty, this theory deals with choices individuals make when the outcomes they face are uncertain.Identify the theory.

Accepted Answer

Expected utility theory extends the concept of utility to situations where there is uncertainty regarding outcomes, providing a framework for individuals to make decisions based on the expected utility of different choices.

Question 18

Individuals can rank order all possible bundles.Rank ordering implies that the utility theory assumes that, no matter how many combinations of consumption bundles are placed in front of the individual, each individual can always rank them in some order based on preferences.Identify this assumption on preference.

Accepted Answer

Completeness is the assumption that individuals can compare and rank all possible bundles of goods, indicating a preference for one over another or indifference between them.

Question 19

According to the utility theory, if bundle A is preferred to B, and bundle B is preferred to C, then A is also preferred to C.Under no circumstances will the individual prefer C to A.Identify this assumption on preference.

Accepted Answer

This assumption is known as rationality, which includes the properties of completeness and transitivity in preferences. The scenario described illustrates transitivity: if A is preferred to B and B is preferred to C, then A is preferred to C.

Question 20

Identify the correct statement about a fair game.

Accepted Answer

A fair game is defined as a game where the expected net outcome (winnings minus cost) is zero, meaning the player neither expects to lose nor gain money in the long run.

Quiz 3: Risk Attitudes: Expected Utility Theory and Demand for Hedging

Why do we say that the utility theory has ordinal utility?

Identify the utility that can represent the absolute level of satisfaction.

Identify the probability that is based on a person's beliefs and experiences, and belongs to the realm of behavioral economics rather than traditional rationality-based economics.

According to the utility theory, a glass of milk mixed with Milo (Nestlè's drink mix) , will be preferred to milk or Milo alone.Identify this assumption on preference.

Identify the utility function of a risk seeking individual.

According to the utility theory, if one week of food is preferred to one week of clothing, then two weeks of food is a preferred package to one week of food.Identify this assumption on preference.

In the utility function of a risk-averse individual, the utility is always increasing although at a decreasing rate.Identify the feature of this utility function.

Daniel Bernoulli was the first one to provide a solution to the St.Petersburg paradox in the eighteenth century.Identify this solution.

Unregulated companies are found to hedge more than regulated ones.

An individual's preference is characterized by the diminishing marginal utility function.Identify the risk attitude of this individual.

An individual's preference is characterized by the increasing marginal utility function.Identify the risk attitude of this individual.

Identify the coding of alternatives that makes individuals vary from E(U) maximizing behavior.

Identify the utility function of a risk averse individual.

In a football tournament, if University of Florida beats Ohio State, and Ohio State beats Georgia Tech, it does not mean that Florida beats Georgia Tech.This scenario violates the rationality assumption on preference of the utility theory.Identify this assumption of preference.

Identify the utility function of a risk seeking individual.

The preferences a risk neutral individual can be captured in E(U) theory by:

While utility theory deals with situations in which there is no uncertainty, this theory deals with choices individuals make when the outcomes they face are uncertain.Identify the theory.

According to the utility theory, if bundle A is preferred to B, and bundle B is preferred to C, then A is also preferred to C.Under no circumstances will the individual prefer C to A.Identify this assumption on preference.

Identify the correct statement about a fair game.