Your utility function is U = In(2C) where C isthe amount of consumption you have in anygiven period. Your income is $40,000 peryear and there is a 2% chance that you will beinvolved in a catastrophic accident that willcost you $30,000 next year.Suppose that 25% of the population iscomprised of individuals like you, who have aprobability of a catastrophic accident, and theother 75% of the population will not face sucha shock. The insurance company knows theincidence of catastrophic accidents in theaggregate, i.e., at the population level, but notto a person. Explain the conditions underwhich an insurance company might offerinsurance (against income loss) to individuals,even if it could not determine who might behit with a large negative income shock andthose who might be hit with a small negativeincome shock.

By covering a large group of individuals (25% in this case), the insurance company can pool the…

to a person. Explain the conditions under which an insurance company might offer insurance (against income loss) to individuals, even if it could not determine who might be hit with a large negative income shock and those who might be hit with a small negative income shock.

to a person. Explain the conditions under which an insurance company might offer insurance (against income loss) to individuals, even if it could not determine who might be hit with a large negative income shock and those who might be hit with a small negative income shock.

ENGR.ECONOMIC ANALYSIS

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ISBN:9780190931919

Author:NEWNAN

Publisher:NEWNAN

Chapter1: Making Economics Decisions

Section: Chapter Questions

Problem 1QTC

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Question

Your utility function is U = In(2C) where C is
the amount of consumption you have in any
given period. Your income is $40,000 per
year and there is a 2% chance that you will be
involved in a catastrophic accident that will
cost you $30,000 next year.
Suppose that 25% of the population is
comprised of individuals like you, who have a
probability of a catastrophic accident, and the
other 75% of the population will not face such
a shock. The insurance company knows the
incidence of catastrophic accidents in the
aggregate, i.e., at the population level, but not
to a person. Explain the conditions under
which an insurance company might offer
insurance (against income loss) to individuals,
even if it could not determine who might be
hit with a large negative income shock and
those who might be hit with a small negative
income shock.

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