ECON 100: Principles of Economics Assignment 4
Due: Friday, Dec 6th, 2019
Time: 3:00 pm
Total Marks: 18
Instructions: All assignments must be handwritten. The assignment is to be submitted in the blue
box in the econ wing. Be sure to write your name and roll number on all submitted material. Give
short, succinct answers. Brevity is your friend (especially in the exams where you’ll be
constrained for time).
Question 1 (6 marks)
Question 2 (4 marks)
Question 3 (3 marks)
Question 4 (5 marks)
Lecture Notes on Uncertainty
Risk-averse people dislike risk and need to be paid a premium to take on risk or uncertainty, or are
willing to pay a premium to reduce uncertainty and risk (eg., insurance). Risk-loving people like
risk and are willing to pay a premium to take on risk. Risk-neutral people are indifferent to risk or
uncertainty and only compare the expected values of different outcomes with varying levels of
uncertainty when making decisions. The expected value of an outcome is its theoretical average
over multiple independent realizations. It is calculated using the following formula:
𝐸 𝑋
𝑥𝑓 𝑥
where 𝑥 is outcome i and 𝑓 𝑥 is its probability.
As an example, consider the toss of a coin as having two possible outcomes, heads or tails, with a
probability of 0.5 each. Let’s suppose you pay Rs. 100 at a carnival to play a game where a coin
is tossed and you win Rs. 200 if the outcome is a head and nothing if it’s tails. Your expected
return from the coin toss is:
E(X) = 200(0.5) + 0(0.5) = Rs. 100
Your expected total winnings (after subtracting the Rs. 100 entry fee) are thus equal to zero. The
expected “winnings” from not playing are trivial – there is only one outcome (Rs. 0) with 100
percent certainty (probability = 1). A risk-averse person would therefore not play this game, since
the expected winnings from either playing or not playing are both equal to zero, but the former has
more risk which he dislikes. A risk-loving person would always play this game and a risk-neutral
person would be indifferent between playing or not playing.
END