Exercise (2pts per question. You need to write the demonstrations to get full points):

You have in total $10,000 in wealth. Your utility function on money: u(x)=ln(x). ln() is the logarithm

function.

a) Suppose you follow Expected Utility Theory. Would you take a gamble where you can gain

$110 or lose $100 with 50/50 probabilities?

b) Suppose that you follow Prospect Theory. Your reference point is the status quo. Your loss

aversion is 1.5, and u(x)=-ln(-x) when x<0. Would you take the gamble?

c)

You learn that you inherit from an old relative $1million. Your reference point is still the same

as in b). Would you take the gamble?

d) You habituate to this new wealth and your reference point becomes this new status quo.

Would you take the gamble?

e) Your lawyer brings you some unexpected news: the inheritance cannot proceed because a

closer heir to your old relative has been found. You will not get anything from the $1million.

Your reference point is still the same as in d). Would you take the gamble?