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PS3 2

1) The document provides instructions for an economics practice problem set regarding risk and insurance. Students are asked to submit their answers to gain access to the answer key. 2) The problem set contains 4 questions about individuals facing risks to property values and incomes, and whether purchasing insurance would be a Pareto improvement over bearing the risks alone or sharing them. 3) Students are asked to calculate expected values, certainty equivalents, optimal insurance coverage levels, and determine if arrangements lead to Pareto improvements.

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hongsik kim
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70 views4 pages

PS3 2

1) The document provides instructions for an economics practice problem set regarding risk and insurance. Students are asked to submit their answers to gain access to the answer key. 2) The problem set contains 4 questions about individuals facing risks to property values and incomes, and whether purchasing insurance would be a Pareto improvement over bearing the risks alone or sharing them. 3) Students are asked to calculate expected values, certainty equivalents, optimal insurance coverage levels, and determine if arrangements lead to Pareto improvements.

Uploaded by

hongsik kim
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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ECON 313 Practice Problem Set 3-2

Instructions: Please use problem sets to practice and review. You will need to submit your
answer at “Assignment” on Brightspace to gain access to the answer key and the graded
“Assignment 3-2” at “Quizzes” on Brightspace. Please note that only one pdf file is accepted.
You can type your answers out and save the file as a pdf file or scan your handwritten
answers. Your submission of this problem set will not be marked. We will only randomly check
if you have attempted every question.
1. Both Howard and Raj have a job paying $100,000 per year. However, there is a probability of 5%
that someone may (though not intentionally) conduct something inappropriate and get fired, in
which case there is no income at all. All events will happen independently. Howard’s utility function
over his income is U=M0.7 while Raj’s is U=M0.5, where M is the annual income each receives.

1) What is the expected annual income for either Howard or Raj?

2) What is the certainty equivalent value of the job package for Howard?

Assume that Howard and Raj decide to share their risks: they will split their combined income
equally no matter what.

3) What are the expected annual income for each of them now?

4) Is it a Pareto improvement for them to share the risk?


2. Betty has a house that is worth $1 million. With a 0.3% probability, there may be a fire which
reduces the value of the house to $0.6m. Betty’s utility function is U(M)=M0.5, where M is the value
of the house (with her insurance if she buys one). An insurance company in a perfectly competitive
market quotes her a fair insurance premium. What is the fair insurance rate (How much does Betty
need to pay for each $ coverage?) How much coverage will Betty choose?
3. Andrew has a house that is worth $500,000. With probability 10% the house will be severely
damaged and the value of the house will be reduced by half. Andrew’s utility function is U(M)= ln
M, where M is the monetary value of his house net off any insurance cost he pays into it.

1) What is the certainty equivalent value faced by Andrew if he chooses not to insure his house?
2) What is the fair insurance rate? Illustrate the budget line and the optimal coverage in your chart
when the fair insurance premium is offered. Make sure you label important points and slopes.
Suppose the current insurance rate is $0.25 per dollar coverage.

3) Add the new insurance budget line to the chart.


4) Illustrate in your chart how much coverage Andrew will get to maximize his utility.

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