Fred and Barney are friends who each own identical holiday houses in the same area of the Snowy Mountains in which bushfires are a known risk. Fred and Barney are both risk-averse.

Illustrate Fred's willingness to pay for full insurance on a diagram.

If Barney is more risk-averse than Fred which of them would be willing to pay more pay more for insurance? Why?

2. Using a diagram, show how mixing a risky and a risk-free asset in a portfolio can make a risk-averse agent better off relative to holding just one of the assets only. 3. Mr Smythe is currently a lender. Following a fall in the interest rate, Mr Smythe remains a lender. Can we determine whether or not he is better or worse off? Illustrate and explain using diagrams. Is your conclusion different if Mr Smythe switches to being a borrower at the lower interest rate? Use diagrams to explain. 4. Aged consumers expend their entire income (an old-age pension) each period on bus trips and all other goods. The Transport Department proposes to increase the discount for senior fares, thus making bus trips cheaper. If the government promises to limit the effect on government expenditure overall, a lump-sum tax must be applied to consumers to offset the cost of the increased subsidy. Using diagrams, explain how the size of the lump-sum tax might be calculated using observable information only. Does this leave consumer welfare unchanged? If not, why not?