PS3 Econ 602

Due Thursday, September 28, 2017 at 7:30

1
The weather is highly unpredictable in Tobago. BetUnFair, Ltd. is a Tobago-
nian based betting and gaming company that offers bets on weather. Specially,
a client can bet $x on weather. If the next days weather is nice and sunny, the
client earns x. If the next days weather is cloudy and rainy, the client loses x.
Rachelle is interested in betting on weather. Assume Rachelles income is
$500 and p is the probability of tomorrows weather being nice and sunny. Her
expected utility function is:

E(U (x)) = plog(500 + x) + (1 p)log(500 x) (1)

(a) Today, Rachelle believes that is will be nice and sunny tomorrow with
probability p = 0.9. How much money (x) will Rachelle bet?

(b) How much money (x) will Rachelle bet if p = 0.4.

2
The probability that Linda suffers an electric overload in her home is p = 0.1.
If there is an overload, Linda will need to replace all of her home appliances.
This will cost her $150. Assume Lindas income is $y and her utility function
is U (x) = log(x).
Linda has the option to buy insurance against an electric overload. De-
note the amount of coverage she purchases as q. Each unit of coverage costs a
premium of p, so if Linda buys q units of coverage, she pays $qp.
If there is an electric overload, Linda will receive $q. If there is not an electric
overload, she receives nothing. Therefore, Lindas expected utility is:

E(U (. )) = 0.1log(y 150 + q pq) + 0.9log(y pq) (2)

(a) If the insurance is actuarially fair, how much is the premium (p) per unit
of coverage?

(b) Assume Lindas income is y = 200. How much coverage will she buy?

1
3
Assume Andrea, who lives in Houston, decided to self-insure her house against
the possibility of flooding. In particular, she wants to raise her house to mitigate
the damage from flooding. For every dollar she invests in raising her house, she
saves herself five times the damage if a flood occurs.
Specifically, when Andrea spends c to self insure, she reduces her loss by
L(c) = 5c.
(a) If Andreas income is y = 200 and the total possible damage that can
occur is valued at d = 100, how much will Andrea invest in self-insuring (i.e
what is c)? Assume the probability of a flood is p = 0.15
Andreas expected utility is:

E(U ) = 0.15log(y d + L(c) c) + 0.85log(y c) (3)

(b) Now assume Andrea can also purchase insurance S for the actuarially
fair price of p = 0.15. How much insurance S and self-insurance c will Andrea
purchase now? What will this mean for the insurance companiys expected
payout?
Note that the new expected utility is:

E(U ) = 0.15log(y d + L(c) c + S 0.15S) + 0.85log(y c 0.15S) (4)