TUTOR HELP FOR ECONOMICS ASAP (Part 3 of 3) Recall that in an expected utility m

Question

TUTOR HELP FOR ECONOMICS ASAP (Part 3 of 3)

Recall that in an expected utility model with a good g and bad b state of nature, preferences over state-contingent consumption bundles (cg, cb) are represented by the utility function.

EU (cg, cb) = (1 p)U (cg ) + pU (cb)   

for some function U , where p is the probability of the bad state occurring. Suppose that Bob has preferences given by (1) with U (c) = c, and that in the absence of insurance his consump- tion would be (cg, cb) = (14, 5). In other words, the loss/damage Bob faces in the bad state is 9 consumption units. Suppose that p = 1/5 and that an insurance company offers Bob the state- contingent consumption bundle (t, 5tt), where t 0 is the premium Bob chooses to pay and 5t is the amount of insurance coverage he receives in the bad state. That is, Bob can choose to add (t, 5t t) of consumption to his current consumption.

Question 3 of 3

c) What will his state-contingent consumption be after he purchases t units of this contract?

Explanation / Answer

The state-contingent consumption after he purchases t units of this contract is

U(CB) = CB-L+A-T= 5-9+14-t= 10-t

So

(cg, cb) = ( 14, 10)

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