ECO206Y1 Study Guide - Midterm Guide: Marginal Product, Utility, Economic Equilibrium

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Published on 20 Jan 2014
School
Department
Course
Professor
ECO206 Microeconomic Theory
1. Midterm II Structure
Based on analysis of past midterms, there are four main topics that are covered in the second midterm of
ECO206: Risk, cost minimization/profit maximization, competitive market equilibrium and short run and
long run decisions. The midterm is usually about 2 hours long and consists of 3 to 5 questions with 3 to 5
sub-questions per question. The total number of questions, including sub-questions, is roughly 12 to 15.
2. Midterm II Statistics
2011
2012
2013
Risk
0
1
1
Cost Minimization
1
1
1
Profit
Maximization
1
0
0
Competitive
Market
Equilibrium
1
0
1
Short Run and
Long Run Decisions
0
1
1
Total
3
3
4
Figure 1 - Midterm II Statistics
Risk
20%
Cost
Minimization
30%
Profit
Maximization
10%
Competitive
Market
Equilibrium
20%
Short Run and
Long Run
Decisions
20%
Midterm II Statistics (2011-2013)
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Topic 1: Risk
Knowledge Summary:
Expected Utility Hypothesis: a decision framework that caters to the environment with
risk/probabilistic outcomes and analyzes the choices available.
For example, consider a simple game: flip a coin for a payoff. Payoffs are $2 if you get heads and
$0 if you get tails. Choices are: receive an amount $c with certainty or play the game. The amount
$c is known as the Reservation Price; i.e. it is the price that makes you indifferent between both
choices
Expected Wealth: EW = 
   i.e. the payoff (xi) times the probability of receiving
that payoff
Expected Utility: EU = 
   where U(xi) is the utility function of the individual
Expected Utility determines the decision that will be made, not expected wealth.
Three types of individuals:
1. Risk Averse likes to avoid risk and minimize risk (concave indifference curve)
2. Risk Neutral is indifferent towards risk (linear indifference curve)
3. Risk Loving gets greater utility from risky prospects than certain ones (e.g. casinos and
gamblers are risk loving and they have convex indifference curves)
To check what type an individual is, we have to compare the utility of the riskless prospect
(receiving a payoff with certainty), denote as P, to the expected utility of the gamble, denote as
C: If P>C then they are risk averse, if P = C they are risk neutral and if P<C they are risk loving
Graph of Risk Averse individual: P>C and A is expected wealth
From graph: level of wealth when U=E(U) is equal to the Certainty Equivalent (xc): an amount
with certainty that gives the same utility as the risky prospect (i.e. A). Maximum amount one is
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willing to pay to insure himself from risk is the difference between (x + δ) and xc, or the
reservation price
Actuarially Fair Insurance: when the cost of the premium for insurance is equal to the expected
benefit of receiving insurance
When insurance is actuarially fair, the individual will insure themselves in full. When insurance
is actuarially unfair, the expected benefit from insurance will be less than the cost of insurance,
therefore the individual will consumes less than full coverage of insurance
Risk premium: graphically the difference between C and A. It is the amount of income a person is
willing to give up in order to avoid a risky situation (averse) or engage in one (loving)
We also have state dependent cases. Monetary payoffs are not all that matters to some
individuals. Therefore, they will not fully insure themselves if they are in a bad state (e.g. lose a
family member).
2 reasons why an individual would not fully insure themselves:
1. Insurance is actuarially unfair
2. State dependent preferences
Summary of Questions to be asked:
Calculating and illustrating expected wealth, expected utility, certainty equivalent and demand for
insurance
Identifying individuals as risk averse, risk loving and risk neutral
Calculating the risk premium
Identifying actuarially fair insurance, good vs. bad states and whether an individual will demand
full coverage or not
Related Past Test Questions:
2012 Midterm II Question 1
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Document Summary

Eco206 microeconomic theory: midterm ii structure. Based on analysis of past midterms, there are four main topics that are covered in the second midterm of. Eco206: risk, cost minimization/profit maximization, competitive market equilibrium and short run and long run decisions. The midterm is usually about 2 hours long and consists of 3 to 5 questions with 3 to 5 sub-questions per question. The total number of questions, including sub-questions, is roughly 12 to 15: midterm ii statistics. Expected utility hypothesis: a decision framework that caters to the environment with risk/probabilistic outcomes and analyzes the choices available. For example, consider a simple game: flip a coin for a payoff. Payoffs are if you get heads and. Choices are: receive an amount with certainty or play the game. is known as the reservation price; i. e. it is the price that makes you indifferent between both choices.

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