Mel is thinking of going on a cruise. Mel values a cruise in nice weather at $2,000 and values a cruise in bad weather at $50. The probability of nice weather is 60 percent and the probability of bad weather is 40 percent. Trip insurance is sometimes available. If purchased, it allows travelers to delay the cruise until the weather is nice. Suppose that the price of the cruise is $1,200. If Mel is risk-neutral, then Mel should:

Question

Mel is thinking of going on a cruise. Mel values a cruise in nice weather at $2,000 and values a cruise in bad weather at $50. The probability of nice weather is 60 percent and the probability of bad weather is 40 percent. Trip insurance is sometimes available. If purchased, it allows travelers to delay the cruise until the weather is nice. Suppose that the price of the cruise is $1,200. If Mel is risk-neutral, then Mel should:

Quizplus · Accepted Answer

In the absence of trip insurance, the expected value of the cruise is  $20 = (0.60)($2,000)+ (0.40)($50)- $1,200. With trip insurance, the expected value of the cruise is $800 = $2,000 - $1,200. Thus, if Mel is risk neutral, then she would be willing to pay up to $780 for trip insurance.

Mel Is Thinking of Going on a Cruise