Consider the following simple insurance example: You have initial wealth w0, but before you consume it, you face a potential loss. Specifically, with probability q you will suffer a loss of $1000 (and otherwise you suffer no loss).

Now, an insurance agent offers to sell you full insurance for a price p.

Suppose that you evaluate lotteries according to expected utility, EXCEPT that your utility function over final wealth is reference-dependent. Specifically, if your final wealth is w and your reference point is r, then your utility is (, ) = + ( ) for some > 1 ,

( ) = 00 xif x x if x x v

(a) Suppose that your reference point is your initial wealth that is, = 0. How much are you willing to pay for this insurance (as a function 0f, , and )?

(b) Suppose instead that your reference point is a function of your choice (because your expectations depend on your choice). Specifically, suppose that your reference point is equal to your final wealth in the no-loss state and so = 0 if you dont buy the insurance, and = 0 if you do buy the insurance. How much are you willing to pay for this insurance (as a function of 0, , and )?

(c) In which case are you more likely to purchase the insurance? Provide some economic intuition for your answer.