Table 1 shows a person\'s utility as a function of wealth. Starting wealth is $8
ID: 1098934 • Letter: T
Question
Table 1 shows a person's utility as a function of wealth. Starting wealth is $80,000. There's a 75% chance of incurring no health care costs and a 25% chance of having to spend $60,000 on health care expenditures, leaving this person with wealth of $20,000. Assuming that this individual wishes to maximize expected utility.
Table 1
Wealth Utility
20,000 0
40,000 10
60,000 15
80,000 16
What is the individual's expected utility if she buys no insurance?
continuing with the information above, what is this individuals's expected utility if she spends $20,000 to purchase insurance covering all medical costs?
Explanation / Answer
Expected Utility (no insurance) = 0.75 * U(W = 80,000) + 0.25*U(W=20000)
= 0.75*16 + 0.25*0
= 12
If this person buys utility, then his wealth is always $80000, however he pays $20,000 for it.
Hence, net wealth = 80000 - 20000 = 60000
Expected Utility (insurance) = U(W=60000) = 15
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