1. Why might some prefer a prix fixe (fixed price) dinner costing about the same as an à la carte one (where you pay individually for each item)? (Assume the food is identical.)
2. Consider a person with the following utility function over wealth: u(w) = ew, where e is the exponential function (approximately equal to XXXXXXXXXXand w = wealth in hundreds of thousands of dollars. Suppose that this person has a 40% chance of wealth of $100,000 and a 60% chance of wealth of $2,000,000 as summarized by P(0.40, $100,000, $2,000,000).
a. What is the expected value of wealth?
. Construct a graph of this utility function (recall your excel?).
c. Is this person risk averse, risk neutral, or a risk seeker?
d. What is this person’s certainty equivalent for the prospect?
3. Consider two prospects.
Problem 1: Choose between
Prospect A:
$2,500 with probability
0.33
$2,400 with probability
0.66
Zero with probability
0.01
Prospect B:
$2,400 with probability
1.00
Problem 2: Choose between
Prospect C:
$2,500 with probability
0.33
Zero with probability
0.67
Prospect D:
$2,400 with probability
0.34
Zero with probability
0.66
It has been shown by Daniel Kahneman and Amos Tversky (1979, “Prospect theory: An analysis of decision under risk,” Econometrica 47(2), XXXXXXXXXXthat 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?