Now, suppose Harry’s utility function is u (w) = ew - 1. He has a house...

Now, suppose Harry’s utility function is u (w) = e^w - 1. He has a house of value $1,000,000. If earthquake comes, it will destroy his house and its value becomes zero. An insurance company provides insurance for those natural disasters. However, they cannot provide full insurance to the house. They provide insurance up to $500,000. The probability of the earthquake is 0.01%. The insurance fee is $0.02 per $1 insured asset. (i.e. if Harry insures $500,000, it will give him $500,000 if the earthquake happens. And the price for such insurance is $100 =$500, 000 × 0.02%.)

(a) Calculate the expected utility of Harry if he doesn’t purchase insurance.

(b) Would it be beneficial to Harry if he buy the insurance? If he dose, what is the optimal amount of insurance that he should buy?

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Expert Solution

Rahul Sunny answered 1 year ago

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