Answer to Question #265679 in Microeconomics for Abs

Question

Given the utility function of an individual, U(W) = 20𝑊, where W stands for wealth.

Comment upon the Risk Aversion of such an individual with the help of a diagram.

(b) Now, let the initial wealth of the individual mentioned above be Rs 400. Suppose this

individual runs a factory, the chances of which catching fire is 1/5. The damage that will be

caused by such fire is estimated to be Rs 300.

(i) What is the expected loss due to the fire?

(ii) What is the expected utility of the individual?

(iii) If the insurance company asks for a premium of Rs 61, would he pay for it?

Answer 1

a.

People's risk aversion refers to their preference for outcomes with low uncertainty over those with high uncertainty, even if the latter's average outcome is equivalent to or higher in monetary worth than the more definite outcome.

b.

(i) expected loss due to the fire

$U(W)=20W\\\frac{1}{5}\times 20=4\\4\times 300=12000$

(ii) expected utility of the individual

$U(W)=4W$

(iii) If the insurance company asks for a premium of Rs 61, would he pay for it?

Yes because the damage is not severe.