1. In a model with uncertainty, there are two “states of the world”. In state on
ID: 3249011 • Letter: 1
Question
1. In a model with uncertainty, there are two “states of the world”. In state one, the consumer has a yearly income of $100,000. In state two, the consumer gets hurt in an accident and cannot work, so he has no income. The probability of an accident is 5%.
a.How much will the consumer agree to pay for insurance that gives him $100,000 compensation in case he has an accident if he is risk neutral?
b.Now suppose the consumer is risk averse. He is offered an insurance that will pay him $100,000 in case of an accident. The insurance costs $2500. Will he buy the insurance? Why or why not?
Explanation / Answer
a)
Expected loss in case of accident = P(Accident) * amount lost = 0.05* 100,000 = $5,000.
So consumer agree to pay anything less than $5,000
b)
Yes, he will take ethe insurance as expected insuarance amount is 5,000 > 2,500 for the same amount of insurance.
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