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In: Economics

Consider a risk averse individual who faces uncertainty with two outcomes: good, bad. The individual has...

Consider a risk averse individual who faces uncertainty with two outcomes: good, bad. The individual has income $360 under good and $90 under bad outcome. The probability of good outcome is 5/9 (so the probability of bad outcome is 1 − 5/9 = 4/9). The individual can buy any non-negative x units of insurance. Every unit of insurance has price $p and it pays $1 in the event of bad outcome.

(a) Suppose the unit price of insurance is p = 1/2. Determine if the insurance market is competitive or not.

(b) Suppose the individual buys x units of insurance. Determine the individual's net income under good income, net income under bad income and the average net income. Draw these three in a diagram as functions of x.

(c) For the individual: (i) compare full insurance with over insurance and (ii) compare full insurance with partial insurance. Then determine best choice of insurance for the individual.

(d) Suppose the individual is risk neutral instead of risk averse. Determine best choice of insurance for the individual.

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Expert Solution

Rahul Sunny answered 1 year ago
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