Suppose Nick has a Von Neumann Morgenstern utility of U = I, where U is utility, I is income, and C is wedding costs. Nick has met the woman of his dreams, Priyanka, and plans to marry her. For a beach wedding, Nick knows there is a 0.5 probability that the wedding will be delayed or relocated because of severe weather. If the wedding is not delayed, Nick's income is $810,000. If the wedding is delayed or relocated, it will cost Nick more money and his income will only be $640,000.
Recall from problem set 5:
Without insurance, Nick's E(U) = 810,000 * 0.5 + 640,000 * 0.5 = 725,000
Let's make it even simpler and just say that Nick's income is $810,000 if the wedding is NOT delayed and $640,000 if the wedding is delayed. If the wedding is not delayed, Nick's income is $810,000. Nick is therefore willing to pay the following to avoid the risk of a wedding delay: 810,000 - P > 725,000 (square both sides) 810,000 - P > 525,625 P < 284,375
What is Nick's certainty equivalent income after wedding costs? That is, what certain income after wedding costs is he willing to accept, rather than accept the uncertain income associated with the risk of wedding delay/relocation? Hint: you almost have it from the answer above.
b. If Nick buys insurance at the P you found in part c AND the wedding is NOT relocated or delayed, his income will be (don't forget the premium and show your work):
810,000 - P
If Nick buys insurance at the P you found in part c, AND the wedding is relocated or delayed, the insurance company will pay him the difference between the client's income if the wedding is relocated/delayed and his income if it is not relocated/delayed.
o What is this difference? (hint: just subtract the two incomes from each other)
810,000 - 640,000 = 170,000
o What is Nick's income if the wedding is delayed? (don't forget the premium)
640,000 + P
d. Joe also has a Von Neumann Morgenstern utility of U = 7. Like Nick, Joe has an annual income of $810,000 if the wedding goes as planned, but only $640,000 in the event of inclement weather. However, Joe is willing to pay P = $121,100 to guarantee an income after wedding costs of $810,000 - P no matter whether the wedding is delayed or not, where P is the insurance premium. Intuitively, is Joe's probability of inclement weather higher or lower than Nick's? Explain.
e. Let r be the probability that Joe needs wedding insurance. What is r for Joe? Show your work.