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nakungth nakungth
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Posts: 1175
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7 years ago
Sam's utility of wealth function is U(w) = 15 .  Sam owns and operates a farm.  He is concerned that a flood may wipe out his crops.  If there is no flood, Sam's wealth is $360,000.  The probability of a flood is 1/15.  If a flood does occur, Sam's wealth will fall to $160,000.  Calculate the risk premium Sam is willing to pay for flood insurance.
Textbook 
Microeconomics

Microeconomics


Edition: 8th
Author:
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wrote...
#1
7 years ago
Sam's expected utility is EV[U(w)]  =   [15 ] +   [15 ].
   = 400 + 8,400 = 8,800.
The level of wealth Sam needs with certainty to ensure this same level of utility is found by solving

U(wC) = 15  = 8,800 for wC.  This will be wC =   = $344,177.76.  Sam's risk premium is then the difference between his current wealth and wC.  This implies Sam is willing to pay $15,822.24 for insurance against a flood.
nakungth Author
wrote...
#2
6 years ago
Thank you!
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