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Scenario: Choosing Insurance
The Ramirez family owns three cars and is considering buying insurance to cover the cost of repairs.They face two possible states: in state 1,their cars need no repairs and their income available for purchasing other goods and services is $50 000;in state 2,their cars need $10 000 worth of repairs and their income available for purchasing other goods and services is reduced to $40 000.The probability of repairs is 10%,while the probability of no repairs is 90%.
-(Scenario: Choosing Insurance)Use Scenario: Choosing Insurance.For $1 000,the Ramirez family can buy insurance that will cover the full cost of repairs.If family members are risk-averse and want to maximize their expected utility,they will:
A) buy the insurance.
B) be indifferent between buying and not buying the insurance since their expected income for purchasing other goods and services is $49 000,regardless of what they do.
C) buy the insurance as long as the utility of having a certain income of $48 000 to buy goods and services other than car repairs is higher than the utility associated with their expected income without insurance.
D) self-insure.

Question

Quizplus · Accepted Answer

The expected cost of repairs is 10% x $10,000 = $1,000. If the Ramirez family buys the insurance for $1,000, they can fully cover the cost of repairs in the event that repairs are needed. Therefore, they will not have to reduce their income available for purchasing other goods and services in state 2. By buying the insurance, the family can eliminate the risk associated with the cost of repairs and maximize their expected utility.

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