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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 $900,the Ramirez family can buy insurance that will cover the full cost of repairs.If family members are risk-averse and 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 $49 100,regardless of what they do.
C) not buy the insurance,since buying it does not increase their expected income for purchasing other goods and services.
D) self-insure.

Question

Quizplus · Accepted Answer

If the Ramirez family is risk-averse and wants to maximize their expected utility, they should choose to buy the insurance. This is because the cost of repairs is $10,000, and there is a 10% chance that they will need repairs, meaning they face a potential loss of $1,000. By buying the insurance for $900, they can eliminate this potential loss, ensuring that their income for purchasing other goods and services will remain at $50,000 whether or not they need repairs. Therefore, buying the insurance gives them a higher expected utility than not buying it.

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