A person has wealth of $500,000. In case of a flood, her wealth will be reduced to $50,000. The probability of flooding is 1/10. The person can buy flood insurance at a cost of $0.10 for each $1 worth of coverage. Suppose that the satisfaction she derives from $ c $ dollars of wealth (or consumption) is given by $ u(c) = \sqrt{c} $. Let $ c_F $ denote the contingent commodity dollars if there is a flood (horizontal axis) and $ c_{NF} $ denote the contingent commodity dollars if there is no flood (vertical axis).1. Determine the contingent consumption plan if she does not buy insurance.2. Assume that the person has von Neumann-Morgenstern utility function on the contingent consumption plans. Write down the expected utility $ U(c_F, c_{NF}) $ and derive the MRS.3. Solve for optimal $ (c_F, c_{NF}) $. To this end, first use the tangency condition (TC) to find the relation between the two contingent commodities $ (c_F, c_{NF}) $. Next, use (BC) to solve for their values. What is the optimal amount of insurance $ K $ the person will buy?(Note: the general theory developed in lectures allows to know the outcome of the exercise. But it is a good idea to work out the problem from first principles.)

Given information: Wealth (W) = $500,000 Incase of flood W goes down by $50,000 (L) Probability of…

A person has wealth of $500,000. In case of a flood her wealth will be reduced to $50,000. The probability of flooding is 1/10. The person can buy flood insurance at a cost of $0.10 for each $1 worth of coverage. Suppose that the satisfaction she derives from c dollars of wealth (or consumption) is given by u(c) = √c. Let CF denote the contingent commodity dollars if there is a flood (horizontal axis) and CNF denote the contingent commodity dollars if there is no flood (vertical axis). 1 Determine the contingent consumption plan if she does not buy insurance.

A person has wealth of $500,000. In case of a flood her wealth will be reduced to $50,000. The probability of flooding is 1/10. The person can buy flood insurance at a cost of $0.10 for each $1 worth of coverage. Suppose that the satisfaction she derives from c dollars of wealth (or consumption) is given by u(c) = √c. Let CF denote the contingent commodity dollars if there is a flood (horizontal axis) and CNF denote the contingent commodity dollars if there is no flood (vertical axis). 1 Determine the contingent consumption plan if she does not buy insurance.

ENGR.ECONOMIC ANALYSIS

14th Edition

ISBN:9780190931919

Author:NEWNAN

Publisher:NEWNAN

Chapter1: Making Economics Decisions

Section: Chapter Questions

Problem 1QTC

See similar textbooks

Similar questions

You have a net worth of $901395 and a utility function given by u(w) = w0.5. If your house %3! catches fire, a 3% likelihood of occurring, you expect it to be total loss and it was recently assessed at $792999. What is the risk premium ($) you'd be willing to pay for full coverage against this fire risk? Hints: Compute the certainty equivalent (CEQ) as you did in Comm 220 and recall that the risk premia is the amount you'd be willing to pay over the expected loss Answer:
Only typed answer
only typed solution
Do it correctly this time
answer this properly, remember (0.35x50)+(0.65x10)=£24 here
1. ) Suppose a driver has a 6% of having one accident a year. In case of an accident the value of the car is reduced from $25,000 to $5,000. If driver buys an insurance policy the insurance company would completely cover damage to the car (essentially restoring its value to its initial level). Assume that the driver's utility function is U = VW. a) If price of the insurance policy (premium) is $1500, would this driver be willing to purchase the policy? Explain Show you computations b) What would be the maximum price a driver with 10% chance of accident be willing to pay for the insurance policy?