Uncertainty and Risk - DARP
Uncertainty and Risk - DARP
Uncertainty and Risk - DARP
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Microeconomics CHAPTER 8. UNCERTAINTY AND RISK<br />
Exercise 8.14 Every year Alf sells apples from his orchard. Although the market<br />
price of apples remains constant (<strong>and</strong> equal to 1), the output of Alf’s orchard<br />
is variable yielding an amount R 1 ; R 2 in good <strong>and</strong> poor years respectively; the<br />
probability of good <strong>and</strong> poor years is known to be 1 <strong>and</strong> respectively. A<br />
buyer, Bill, o¤ers Alf a contract for his apple crop which stipulates a down payment<br />
(irrespective of whether the year is good or poor) <strong>and</strong> a bonus if the year<br />
turns out to be good.<br />
1. Assuming Alf is risk averse, use an Edgeworth box diagram to sketch the<br />
set of such contracts which he would be prepared to accept. Assuming that<br />
Bill is also risk averse, sketch his indi¤erence curves in the same diagram.<br />
2. Assuming that Bill knows the shape of Alf’s acceptance set, illustrate the<br />
optimum contract on the diagram. Write down the …rst-order conditions<br />
for this in terms of Alf’s <strong>and</strong> Bill’s utility functions.<br />
b<br />
x RED<br />
a<br />
x BLUE<br />
0 b<br />
R 2<br />
•<br />
D<br />
0 a a<br />
R 1<br />
x RED<br />
b<br />
x BLUE<br />
Figure 8.2: Acceptable contracts<br />
Outline Answer:<br />
1. In Figure 8.2 the contours represent Alf’s indi¤erence curves: note that<br />
they are convex to the point 0 a (risk aversion) <strong>and</strong> that they have the same<br />
slope [1 ] = where they cross the 45 ray through 0 a (consequence of<br />
von-Neumann utility function). Point D represents the initial endowment;<br />
Alf’s endowment is (R 1 ; R 2 ). Alf’s indi¤erence curve through point D<br />
represents the boundary of the set of consumptions that Alf would regard<br />
as being at least as good as the initial endowment: the shaded area is his<br />
acceptance set. The buyer (Bill) has an endowment K that is independent<br />
of the state of the world –see Figure 8.3. Note that the indi¤erence curves<br />
for Bill also have the slope [1 ] = where they cross the 45 ray through<br />
0 b :<br />
2. Point E in Figure ?? represents the optimum contract (from Bill’s point<br />
of view) since it is a point of common tangency of two indi¤erence curves.<br />
cFrank Cowell 2006 134