Question

What does it mean for consumers to maximise their expected utility? Can you think of a case where a person might not maximise his/her expected utility? Why do people often want to insure fully against uncertain situations even when the premium paid exceeds the expected value of the loss being insured against?

Answer 1

Solution

For the consumers,maximizing their expected utility means a consumer consuming a particular good up to the level where his/her marginal utility derived out of consuming each additional unit of good consumption will keep on increasing.

According to the law of marginal utility,the marginal utility increases upto a point,then it remains stable till sometime and then it begins to decline.

There might be several reasons.I could think of the following reasons:

1.In case of Life Insurance,there is no limit to getting insured..So,people generally insure themselves well beyond their estimated economic value of wealth they would generate if at all they are alive.

2.Inability of the people to arrive at the probability of loss.So,ultimately their inability to arrive at the expected value of loss.

3.Some people are too-much risk-aversive that they miss out on this common logic

4.The premiums in the initial young years of any person is less and remains the same.But if they enroll afterwards it becomes costly.So,they enroll early and since they are in peak productive phase of their life and due to comparatively lower premiums they usually pay higher premiums and avail a life cover which is more than their estimated loss to their family

Hope this solution helps!! Please give a "Thumbs Up " rating for this solution !!