Question

1. Suppose that John has an income of $50,000 when healthy. If he falls sick, he...

1. Suppose that John has an income of $50,000 when healthy. If he falls sick, he has to pay $10,000 to cover his medical bills. There is a 40% probability that John will become sick.

a. Calculate John’s expected income E (I).

b. Suppose that John’s utility function is: U(I) = ln (I). Calculate John’s expected utility of income E (U(I)).

c. Calculate the utility of John’s expected income U (E (I)). Compare this value to your answer in (b). Is John risk averse?

d. Calculate John’s risk premium. Will John buy an insurance plan that charges a premium of $5,000 and has a payout of $10,000? Explain.

(Hint: calculate income in the sick and healthy state under this insurance plan.)

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