A person has a 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).(a) Determine the contingent consumption plan if she does not buy insurance.(b) Determine the contingent consumption plan if she buys insurance $K.(c) Use your answer in (b) to eliminate K and construct the budget constraint (BC) that gives the feasible contingent consumption plans for different amounts of insurance K. Determine the slope of the budget line (both graphically and by forming the price ratio).

Answered: A person has wealth of $500,000. In…

ENGR.ECONOMIC ANALYSIS

14th Edition

ISBN:9780190931919

Author:NEWNAN

Publisher:NEWNAN

Chapter1: Making Economics Decisions

Section: Chapter Questions

Problem 1QTC

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A person has a 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).

(a) Determine the contingent consumption plan if she does not buy insurance.

(b) Determine the contingent consumption plan if she buys insurance $K.

(c) Use your answer in (b) to eliminate K and construct the budget constraint (BC) that gives the feasible contingent consumption plans for different amounts of insurance K. Determine the slope of the budget line (both graphically and by forming the price ratio).

Expert Solution

Step 1

Contingent Consumption is the consumption by the purchaser in case of uncertain conditions. The purchase of insurance in such a situation is done to meet the future uncertainties and maintain the same sum of wealth as before the happening.

Let K be the number of units of insurance
The cost of Insurance for $1 is 0.1
The cost of insurance for M unit is 0.1K

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