Homework Clinic
Social Science Clinic => Economics => Microeconomics => Topic started by: ts19998 on Jul 1, 2018
-
For the utility function U = Wa, what values of a correspond to being risk averse, risk neutral, and risk loving?
What will be an ideal response?
Question 2
Johnny owns a house that would cost 100,000 to replace should it ever be destroyed by fire. There is a 0.1 chance that the house could be destroyed during the course of a year. Johnny's utility function is U = W0.5. How much would fair insurance cost that completely replaces the house if destroyed by fire? Assuming that Johnny has no other wealth, how much would Johnny be willing to pay for such an insurance policy? Why the difference?
What will be an ideal response?
-
Answer to Question 1
0 < a < 1 implies risk averse.
a = 1 implies risk neutral.
a > 1 implies risk loving.
Answer to Question 2
Fair insurance would cost (0.001 100,000 ) = 100. Johnny's expected utility without insurance equals (.001 00.5 ) + (.999 100,0000.5 ) = 315.91. He can receive this level of utility with certainty if he had risk-free wealth of 99,800.10. Thus, he is willing to pay 199.90 for insurance. He is willing to pay more than the fair price because he is risk averse.
-
thank you