Question

Assume that Wonku drives a car carrying a market value of $10,000. The only other asset he owns is the $3,000 in his checking account. Thus, he has a total initial wealth of $13,000. If he drives carefully, he incurs a cost of $3,000.

Assume he faces the following loss distributions when he drives with or without care.

Drives with care		Drives without care
Probability	Loss	Probability	Loss
0.25	10000	0.75	10000
0.75	0		0

Now, when he has an accident, his car is a total loss. Wonku’s problem has four parts: whether to drive with or without care, when i) he has no insurance; and ii) when he has insurance. Assume that the insurance company has a premium of $2875. Will Wonku switch to driving without care after purchasing insurance? At what level of premiums will Wonku become indifferent between driving with or without care? Assume Wonku’s utility of wealth is given by U(W) = 20 + .

(Please show work Typed not handwritten!)

Answer 1

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