Only answer question d. e. f.

Question 1: [17 marks total] (+ 2 bonus) A lottery bond is a type of government bond in which investors receive reduced interest, or none at all, and instead receive a chance of a prize. Examples included the premium bond in the UK. Suppose that the government runs a lottery experiment in order to help them understand how to price the bonds. Suppose they offer small lotteries to consumers that are based on the outcome of a game in which the color red and black appear at random. Let R be the amount of money that the consumer receives if red occurs (the "red state of the world") and B be the amount of money the consumer receives if black occurs (the "black state of the world"). Suppose p is the probability of red, with 0 < p < 1. Suppose consumers have a utility of money given by u(m) = ln m, and that their preferences over these lotteries paying R with probability p and B with probability 1 p can be characterized by the expected value of their utility of money.

(a) [4 marks] Assume that p = .75 and that Ann is endowed with a lottery A that pays 50 dollars in the red state and 100 dollars in the black state. Letting the horizontal axis be the red state amount and the vertical axis be the black state amount, on the same graph (i) draw Ann's indifference curve passing through the point representing lottery A (label it "IC"), (ii) draw all positive payoff combinations of (R, B) that produce the same expected value as this lottery (label it "same EV"), (iii) draw all positive payoff combinations that yield the same payoff in each state (label "same payoff"),and indicate with "C" the lottery on the "same payoff" line that satisfies A C according to Ann, and indicate with "B" the lottery on the "same payoff" line that the risk neutral government would find equivalent to A (this B has nothing to do with the black state of the world). Mark the amount of money corresponding to A, B, C on the horizontal and vertical axis. The graph is enough, no need to justify.

(b) [2 marks] What is the least amount of money Ann would be willing to accept in exchange for lottery A from part (a)? Please justify briefly.

(c) [2 marks] Suppose the government offers Ann a lottery with p = .75, R = 100, and B undetermined . What is least B Ann would be willing to accept in exchange for this lottery instead of the A she is endowed with from part (a)? Please justify briefly.

(d) [3 marks] Suppose the government gives Ann a lottery in which p = .75 R = B = 100 dollars. Keeping p fixed, (i) what is the (instantaneous) rate at which Ann would be willing to give up money in the black state for more money in the red state, per dollar of extra money in the red state? (ii) what is the most amount money Ann would be willing to give up in the black state for an extra 25 dollars in the red state? Please justify briefly.

(e) [2 marks] Given p, R, B, Ann's value of a dollar in the red state is the rate at which Ann is willing to give up money in the black state for more money in the red state, per dollar of extra money in the red state. How does Ann's value of a dollar in the red state depend on p, R, B, i.e. for an increase in p, R, and,B respectively, is Ann's value of a dollar in the red state increasing, decreasing or constant? Please justify briefly.

(f) [4 marks] On a new graph with the red state on the horizontal axis, using Ann's indifference curve through certain lottery "basket" P = (R, B) = (10, 10) as a reference and assuming p = .75, plot the indifference curve over lotteries that passes through (R, B) = (10, 10) for each of four other individuals i = 1, 2, 3, 4 with utility functions of money given by ui(x), and with each of their preferences over lotteries characterized by the expected value of their utility of money. Assume that i = 1 is risk seeking, i = 2 is risk neutral, i = 3 is risk averse, but less so than Ann, wand i = 4 is risk averse, but more so than Ann. What this means is that: if i = 4 strictly prefers lottery "basket" E over P (written "E 4 P"), then so does Ann, (written "E A P"), also, if Ann strictly prefers D over P, i.e. "D A P", then so does i = 3, i.e. "D 3 P." In this way, this also means that if C 3 P then C 2 P and, finally that if B 2 P then B 1 P. Further assume the "basket" A is defined so that A 1 P but P 2 A. Along with the stylized indifference curves, plot the five lottery "baskets" A, B, C, D, E that satisfy the criteria just above under the assumption that they each pay strictly more in the red state than in the black state. Please briefly justify the relative location of the indifference curves, and the location of A, B, C, D, E.