Answer both questions. Your answers to any one question must not exceed 700 words
Problem 1. If X is a normal good, then a fall in price must lead to a rise in consumption, but if X is an inferior good then a fall in price may lead to a rise in consumption. Answer TRUE or FALSE and justify your answer in terms of income and substitution effects.
Problem 2. Suppose that George’s utility function is given by u(w) = 1000w – 0.5w2, where w is his income/wealth
a) Is George risk loving, risk averse or risk neutral?
b) Suppose that George is offered a 50:50 gamble between 30 and 50 i.e he will receive £30 with probability 0.5 or he will receive £50 with probability 0.5. Calculate the certainty equivalent and explain what it signifies
c) Calculate the risk premium and the maximum amount George is willing to pay for insurance. Explain
d) Illustrate your answers for parts (a) through to (c) in an appropriately labelled diagram.