A decision-maker with initial wealth w faces a probability of incurring a loss. If the loss occurs, with probability p the amount of the loss is ₁ and with probability 1-p the amount of the loss is £2, where ₁>₂ > 0. The decision-maker can buy insurance against both losses at a price of q dollars per unit. If she purchases z units of insurance, she receives z dollars if either loss occurs, even if z is greater than the amount of the loss. There is no limit to the amount of insurance she can purchase. (a) First suppose that the decision-maker is a risk averse expected utility maximizer with von Neumann-Morgenstern utility u(y) over quantities of wealthy. i. (Write down the first-order condition characterizing the optimal choice of z when it is interior. Solution: The first-order condition is (1−q)ñpu² (w − l₁ + (1 − g)x)+(1−g)x(1−p)u' (w − l₂ + (1 − g)x) = g(1−z)u'(w—qx). ii. (, Is the highest price q at which the decision-maker fully insures against the larger loss ₁ greater than, equal to, or less than ? Prove your answer. Solution: Atq=, the above FOC simplifies to pu' (w-l₁ + (1-9)x) + (1 − p)u' (w − l₂ + (1 − q)x) = u(w − qr). I If z = {₁, the left-hand side of this equation is smaller than the right-hand side. Since u' is decreasing, we must have r
A decision-maker with initial wealth w faces a probability of incurring a loss. If the loss occurs, with probability p the amount of the loss is ₁ and with probability 1-p the amount of the loss is £2, where ₁>₂ > 0. The decision-maker can buy insurance against both losses at a price of q dollars per unit. If she purchases z units of insurance, she receives z dollars if either loss occurs, even if z is greater than the amount of the loss. There is no limit to the amount of insurance she can purchase. (a) First suppose that the decision-maker is a risk averse expected utility maximizer with von Neumann-Morgenstern utility u(y) over quantities of wealthy. i. (Write down the first-order condition characterizing the optimal choice of z when it is interior. Solution: The first-order condition is (1−q)ñpu² (w − l₁ + (1 − g)x)+(1−g)x(1−p)u' (w − l₂ + (1 − g)x) = g(1−z)u'(w—qx). ii. (, Is the highest price q at which the decision-maker fully insures against the larger loss ₁ greater than, equal to, or less than ? Prove your answer. Solution: Atq=, the above FOC simplifies to pu' (w-l₁ + (1-9)x) + (1 − p)u' (w − l₂ + (1 − q)x) = u(w − qr). I If z = {₁, the left-hand side of this equation is smaller than the right-hand side. Since u' is decreasing, we must have r
Chapter7: Uncertainty
Section: Chapter Questions
Problem 7.4P
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what is the optimizatio formula that was use for foc? please solve
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