BITS, PILANI- Hyderabad Campus

Second Semester, 2023-24

BEHAVIORAL ECONOMICS: ECON F345
Assignment 1
Due Date: 04:50 PM, 06th March, 2024 Max. Marks: 18
Weight: – % (Total Assignment Weight: 10 %)

ˆ Write your answers very clearly and neatly.

ˆ Arguments and steps should be precise and complete.
ˆ For all the questions, you need to provide the complete derivation.
ˆ You need to write your answers neatly, with proper margins. It can be either hand-
written or typed. The entire assignment should be written on homogenous sheets in a
legible manner! 2 marks are for these!

1. Suppose there are only two types of mutual fund managers: skilled and unskilled.
Suppose skilled managers outperform the stock market index in 90% of all years, while
unskilled managers outperform the stock market index in 50% of all years. Also assume
managers’ performance is independent across years. Further suppose that 90% of
mutual fund managers are unskilled, and only 10% are Skilled.
(a) Suppose a fund (Delta One Ltd.) that started up three years ago has outperformed
the stock market index for all three years. What is the probability that its manager
is a skilled one? 1 marks
(b) Now consider an investor who is unaware of this 90% : 10% distribution, the
investor think that a fund manager is equally likely to be a skilled and a unskilled
one. So as per this investor’s assessment, what is the probability of the fund
(Delta One Ltd.) manager being a skilled one? 1 marks
2. In 1953, Maurice Allais proposed the following thought-experiment. You must make a
choice between Gamble A and Gamble B (you can interpret these dollar amounts as
final wealth levels):
Gamble A: $1 million for sure
Gamble B: $ 1 million with probability 0.89, $ 5 million with probability 0.10, .$0 with
probability 0.01.
Next, you must make a choice between Gamble C and Gamble D:
Gamble C: $1 million with probability 0.11, $0 with probability 0.89,
Gamble D: $5 million with probability 0.10, $0 with probability 0.90
Most people choose Gambles A and D. Explain why (no matter what utility function a
person has!) this pattern of choices violates expected utility theory. Very clearly write
your arguments. 1 marks

ECON F213 Assignment-1 Page 1 of 4

 3. Suppose you are owning a house and your current wealth level is worth Rs. 3 Crores.
Lets say, there is risk of a damage to the house (maybe due to fire or so) with probability
0.01. In case of damage, it requires Rs. 45 lakhs to repair. Suppose your utility function
1
is given by u(w) = w 2 , where w is the final wealth level.

(a) What is the certainty equivalent and risk premium of this lottery if you are an
expected utility maximiser? 1 marks
(b) Now you have an option of purchasing a insurance against this damage. What
is the maximum insurance premium that you will be ready to pay if you are a
expected utility maximiser? 1 marks

4. Consider three investment options- risky1, risky2 and a safe one. Further suppose that
the economy can be good, avg, or in poor shape. The returns are as follows-
Good Avg Poor
Safe 120 110 105
Risky1 150 120 65
Risky2 140 130 75
What is the optimal investment option as per the maximin approach? What is the
optimal investment option as per the maximax approach? What is the optimal invest-
ment option as per the minimax-risk approach? 1
marks

5. (a) Consider the following game-

A B C
A 2,5 3,7 1,2
B 1,4 6,3 10,10
C 5,3 4,6 7,6
Derive the pure strategy Nash equilibrium here. Also verify whether any player
has a strictly or weakly dominant strategy. 1 marks
(b) Consider the following total cost function-
(
50 + 2Q if Q > 0
T C(Q) =
0 otherwise

Do we have a sunk cost here? Give a brief explanation. 1 marks

(c) Consider the following Fehr-Schimdt utility function-
1
ui (xi , xk ) = xi − max{xk − xi , 0} − max{xi − xk , 0}
4
Suppose you are richer than the other individual. In order to give an amount
x > 0 to the other individual, how much of a cut you are ready to take? Clearly
show your derivation. 1 marks

ECON F213 Assignment-1 Page 2 of 4

 6. Consider two firms, say A and B. Suppose both of these firms produce same good, say
Q. The cost functions of these two firms are same except for the fixed cost components.
Suppose fixed cost for firm A is FA and that for firm B is FB , and FA > FB . Here
we assume that both firms are rational. What should be the relation between QA and
QB ? Explain very clearly, considering all possible cases. 1 marks

7. Suppose a box contains 20 coins- 14 of them are fair i.e. both Head (H) and Tail (T )
are equally likely, 3 of them have both sides H, and 3 of them have both sides T . A
coin is picked randomly and tossed- if its H, you get Rs. 1700; else you get 1200. You
are not allowed to inspect the coin, you can just see the outcome of tosses.
Further suppose first toss happens to be T . Now what is the maximum amount that
you will be ready to pay to play this game for the second toss (same coin)? Assume
that you are a expected utility maximiser with a risk averse attitude. 1 marks

8. Consider following lotteries-

L1 = (Rs.5000, 0.30; Rs.1000, 0.70) L2 = (Rs.4000, 0.40; Rs.1000, 0.60)

L3 = (Rs.5000, 0.12; Rs.1000, 0.88) L4 = (Rs.4000, 0.16; Rs.1000, 0.84)

Verify that in the presence of independence axiom and reduction axiom, L1 < L2
implies L3 < L4 . Clearly write your arguements showing each steps of derivation. 1
marks

9. Consider the following game. A die is being tossed repeatedly. In any roll, if the
number is greater or equal to 4 (event H), you get Rs. 100; and Rs. 1000 if it’s less
than or equal to 3 (event L). Before each roll, you need to decide whether you want to
participate in the game - there is an entry fee of Rs. F. Further you believe that the
die is either fair (p = 16 for each number); or biased where getting H has p = 25 and L
has p = 53 . Suppose that to start with you believe that the coin is fair with 60 per cent
probability and unfair or biased with 40 per cent probability. You are not allowed to
verify the fairness of die, you can just see the outcome of the roll. Use the expected
value approach and Bayesian updation to answer follwoing questions. 1 mark

(a) What’s the maximum entry fee that you will be ready to pay for the 1st roll?
(b) What’s the maximum entry fee that you will be ready to pay for the 2nd roll if
the outcome of the first roll is L?
(c) What’s the maximum entry fee that you will be ready to pay for the 2nd roll if
the outcome of the first toss is H?

10. Consider the following hypothetical facts- “Only 1 percent of people in the world are
rational. We have a test for rationality. If someone is rational, they have a 90 % chance
of passing. If someone is irrational, they have a 30 % chance of passing. Alexa has just
given the test and qualified.” Assume that Alexa was drawn randomly from the world
population. What is the probability that Alexa is truly rational? 1 mark

ECON F213 Assignment-1 Page 3 of 4

 11. Consider two lotteries- 2 marks

L1 = {200, 0.20; 400, 0.50; 500, 0.30}

L2 = {500, 0.10; 300, 0.70; 100, 0.20}

(a) Check for first-order stochastic dominance between these lotteries.

(b) Consider an expected utility maximiser with the utility function u(x) = ln x.
Which lottery is going to be preferred? What is the risk premium (RP) of the
lottery L1 ?
(c) Consider a decision maker who follows the modified expected utility approach
(MEU). Assume the utility function to be u(x) = ln x and the probability weight
function to be
p0.50
w(p) = 0.50
{p + (1 − p)0.50 }2
Which lottery is going to be preferred?

ECON F213 Assignment-1 Page 4 of 4