Question

Suppose you face a choice between a certain income of $5,000, or a 50-50 chance of income of $2,500 or $7,500. Suppose you prefer the certain $5,000.

True or False: You are risk averse.

True

False

Suppose that a disease affects 2% of the population and that everyone is equally likely to get the disease. Treatment for this disease costs $36,000. Assume that this disease, and necessary treatment, represent the only healthcare costs in this population.

The expected cost of healthcare is(    $). If people (prefer/not prefer) to pay the expected cost of healthcare with certainty, rather than take on the 2% risk of having to pay the full cost of the treatment, they are risk averse.

Answer 1

1)

Expected value of offer=0.5*2500+0.5*7500=$5000

A risk averse person will prefer the certain amount as compared to gamble if expected value is same. Certain amount is equal the expected value of gamble and person prefers the certain amount, it implies that the person is risk averse.

Correct option is

True

2)

Probability of disease=p=2%

Healthcare expenditure in case of disease=L=$36000

Expected cost of treatment=p*L=0.02*36000=$720

If people prefer to pay the expected cost of healthcare with certainty rather than take on the 2% risk of having to pay the full cost of treatment, they are risk averse.