Question

Suppose ashok's utility function is . His initial income when healthy is 36,000. However, there is a 50% chance that she will face financial loss on being taken ill and the income is likely to reduce by 20,000. 4 (a) find the expected value of his income (b) what expected utility he will have given the possible state of her health? (c) what is the risk premium he will be willing to pay to cover the risk of sickness?

Answer 1

u = {I/1000}1/2. I1 = 36000, I2 = 16000.

1) The expected value of Ashok’s income is:

I = 0.5*36000 + 0.5*16000 = 26000.

2) Expected utility Ashok gave in the possible state of his health is:

u = 26000/1000*1/2 = 13.

3) The risk premium is about 50% to shelter the possibility of illness.