I5

Suppose have the utility function over wealth outcomes, x, that can be described by U(x)= . You currently have $81,000 in wealth, but there is a 1/3 chance that you might experience a $45,000 loss. There exists insurance contracts that would fully reimburse the loss in the event it occurs.

a) What is the maximum amount you would pay to purchase such a full-insurance contract? Draw an appropriate graph to illustrate how the insurance policy is preferred by you compared to taking the risk of the loss (to make the numbers easier, assume the x-axis for wealth is defined in thousands of dollars. So, a wealth level of $81,000 would be $81 on that axis....just don't forget it is "thousands" of dollars).

b) Suppose an insurance policy to fully cover the $45,000 loss (that occurs with 1/3 chance) costs $15,000. Would a risk averse person buy this policy? Would a risk neutral person buy this policy? Question Would a risk loving person buy this policy? What is your reasoning for these answers above?