James has a current wealth of $90,000, including his brand new Cadillac which is worth $50,000....

James has a current wealth of $90,000, including his brand new Cadillac which is worth $50,000. His son just got a driver’s license and Peter is contemplating whether to (i) let his son borrow the Cadillac, or (ii) buy him a used car as a gift. James estimates that the likelihood that his son will total the Cadillac is around 10% and the used car will cost somewhere between $5,000 and $6,000.

a. If James’s utility function is given by u(x)=x^(1/2), then what is his expected utility from letting his son borrow the Cadillac?

b. What is the maximum amount that James would be willing to pay to buy his son a used car as a gift?

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Expert Solution

Rahul Sunny answered 1 year ago

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