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STAT 131: Quiz 7 140 total points
Name:
Someone offers you the possibility to play a gambling game with the following rules. First,
you decide how much money you’re willing to put at risk in this game: this amount — let’s
call it A > 0 — is referred to as your stake (all the monetary quantities are in dollars in this
problem); think of A as a fixed known positive real number in what follows. Having chosen
your stake, you’re allowed to bet any amount 0 ≤ B ≤ A (thus, as a decision problem,
your possible actions in this situation correspond to values of B). If you win the bet, which
occurs with probability 0 < p < 1, your stake becomes (A + B); if you lose, it becomes
(A−B), and losing (of course) occurs with probability (1−p); and (crucially) p is known
to you. Let X denote the value of your stake after the gamble has occurred. The point
of this problem is to explore your optimal betting strategy, assuming the Principle of
Maximization of Expected Utility (MEU), for two different reasonable-looking utility
functions, to see which one leads to more sensible behavior.
(a) Write out the probability mass function (PMF) for X. 5 points
(b) 20 points for this part of the problem First let’s suppose that for you, utility
coincides with money, i.e., U1(x) = x.
(i) Work out your expected utility E[U1(X)] as a function of A,B and p. 5 points
1
(ii) Holding A > 0 and 0 < p < 1 constant, what type of function of B is this?
Explain briefly. 5 points
(iii) Using plotting software (or making freehand sketches) and including any result-
ing PDF files in your solution document, graph the expected utility function in
(i) for 0 ≤ B ≤ A in the three separate cases (p < 1
2
), (p = 1
2
), (p > 1
2
); you can
use A = 10 and p = (0.1, 0.5, 0.8) as examples. 10 points
(c) 35 points for this part of the problem Now let’s maximizeE[U1(X)] as a func-
tion of B.
(i) Compute the first partial derivative of E[U1(X)] as a function of B, and try
setting it equal to 0 and solving for B. With reference to your graphs in (b),
briefly explain why this standard calculus approach to maximizing a function
won’t work in this problem. 10 points
2
(ii) By considering the three different cases for p mentioned above, and with par-
ticular reference to your sketches in (b), briefly explain why B∗1 , the optimal B
under U1, is as follows:
B∗1 =
0 (don’t bet) if p < 1
2(
bet any number
between 0 and A
)
p = 1
2
A (bet it all) p > 1
2
(1)
10 points
(iii) Identify one feature of this betting strategy that seems reasonable, and two
features that seem unreasonable, in all three cases as a function of p; explain
briefly. 15 points
(d) 50 points for this part of the problem Next, let’s suppose instead that you
use Daniel Bernoulli’s utility function U2(x) = 1 + log(x).
(i) Work out your expected utilityE[U2(X)] as a function ofA,B and p. 10 points
(ii) Take A = 10 for illustration and get Wolfram Alpha (or some other equivalent
environment) to plot this as a function of B from −5 to A for two different values
of p: 0.4 and 0.7; reproduce these plots in your solutions, either electronically
or by hand-sketching what your software environment showed you. 10 points
3
(iii) Holding A > 0 and 0 < p < 1 constant, what type of function of B is this
(increasing, decreasing, concave, convex)? Explain briefly. 10 points
(iv) Compute the first partial derivative of E[U2(X)] with respect to B, set this
expression to 0, and solve for B. 10 points
(v) In many problems the computation in (iv) would yield the optimal B∗ (the value
of B that maximizes the expected utility), but the situation is a bit more subtle
here. Identify the range of values of 0 < p < 1 for which the B∗ you obtained
by differentiation cannot be the solution to this optimality problem, and briefly
explain why. 10 points
4
(e) 20 points for this part of the problem Specifying the optimal B with the log-
arithmic utility function.
(i) By examining the two different cases (p ≤ 1
2
), (p > 1
2
), briefly explain why B∗2 ,
the optimal B under U2, is as follows:
B∗2 =
0 (don’t bet) if p ≤ 1
2
2
(
p− 1
2
)
A
(bet an amount
between 0 and A
in proportion to
how much bigger
p is than 1
2
)
p >
1
2
, (2)
10 points
(ii) Identify two features of this betting strategy that seem eminently reasonable;
explain briefly. 10 points
5
(f) Is it fair to describe one of the two betting strategies above, based on the two different
utility functions, as more risk-seeking than the other one? If so, which is which? If
not, why not? Explain briefly. 10 points