Question

In: Economics

Assume that Wonku drives a car carrying a market value of $10,000. The only other asset...

Assume that Wonku drives a car carrying a market value of $10,000. The only other asset he owns is the $3,000 in his checking account. Thus, he has a total initial wealth of $13,000. If he drives carefully, he incurs a cost of $3,000.

Assume he faces the following loss distributions when he drives with or without care.

Drives with care

Drives without care

Probability

Loss

Probability

Loss

0.25

10000

0.75

10000

0.75

0

0

Now, when he has an accident, his car is a total loss. Wonku’s problem has four parts: whether to drive with or without care, when i) he has no insurance; and ii) when he has insurance. Assume that the insurance company has a premium of $2875. Will Wonku switch to driving without care after purchasing insurance? At what level of premiums will Wonku become indifferent between driving with or without care? Assume Wonku’s utility of wealth is given by U(W) = 20 + .

(Please show work!)

Solutions

Expert Solution

Consider the image above for the working solution to the question. Utility function is not clearly stated so assumed Wonku's utility to be directly equal to his wealth. DwC refers to drive with care and D w/o C refers to drive without care. Without insurance, Wonku will prefer to drive with care, while with insurance he will prefer to drive without care.

Rahul Sunny answered 1 year ago
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