John just purchased a new car today and paid $40K for it. He needs to go to Otta

Question

John just purchased a new car today and paid $40K for it. He needs to go to Ottawa tonight but there is a weather warning that roads are full of black ice and dangerous to drive. The dealer can only issue a mandatory liability insurance that covers only damages to other cars and persons but not the John's car. He knows that there is a 90% chance that he will not have an accident. But if it happens he will lose his car. Suppose that it's late and all insurance brokers are closed, all flights are full, and he missed the last bus. Canceling the trip will cost him $4,000. He is just thinking the best possible action. Since you are his best friend taking Public Finance at SMU, he calls you to get your opinion. Using your own utility function and calculating expected utilities, how would you advise him? Justify your answer with numbers. Would you change your answer if the probability of no-accident were 99%? Why? What amount of cost would change your answer in (a)? Explain your answer by calculating CEW.

Explanation / Answer

You calculate expected utility using the same general formula that you use to calculate expected value. Instead of multiplying probabilities and dollar amounts, you multiply probabilities and utility amounts. That is, the expected utility (EU) of a gamble equals probability x amount of utiles.

E(UlU)= 0.9* 4000=3600

With probability of 99%

E(U)= 0.99*4000=3960

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