Question
Consider a consumer with each of the following utility functions: i) u ( x )= e -x ii) u ( x )=ln( x ) iii)
Consider a consumer with each of the following utility functions:
i) u(x)=e-x
ii) u(x)=ln(x)
iii) u(x)= x1/2
2a. For each of the utility functions above, compute the coefficient of absolute risk aversion and the coefficient of relative risk aversion.
The consumer faces one of two possible risks:
La: with probability 1/2, no loss occurs, and with probability 1/2, a loss of $10 occurs.
Lb: with probability 1/2, no loss occurs, and with probability 1/2, a loss of 10% of wealth occurs.
2b. Compute the maximum a consumer with utility function (i) above will pay for full insurance against risk La when initial wealth is w = 100 and when initial wealth is w = 200.
2c. Compute the maximum a consumer with utility function (ii) above will pay for full insurance against risk Lb when initial wealth is w = 100 and when initial wealth is w = 200.
2d. Compute the maximum a consumer with utility function (iii) above will pay for full insurance against risk La when initial wealth is w = 100 and when initial wealth is w = 200.
2e. Part b of this question illustrates constant absolute risk aversion. Part c illustrates constant relative risk aversion. Part d illustrates decreasing absolute risk aversion. Very briefly explain how.
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