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% and the probability of bad weather is 40%. Trip insurance is sometimes available. If purchased, it allows travelers to delay the cruise until the weather is nice. If Mel is risk-neutral, then in the absence of trip insurance, the most she will be willing to pay for the cruise is _______.

Question

Quizplus · Accepted Answer

Since Mel is risk-neutral, her expected utility from the cruise is simply the expected value of the utility of the two possible outcomes. 
Expected utility (without insurance) = 0.6($2,000) + 0.4($50) = $1,210

Since Mel is only willing to pay for the cruise if her expected utility is at least $1,210, the maximum amount she will be willing to pay is $1,220, which is the highest amount that still yields an expected utility of at least $1,210. Therefore, the best choice is (C) $1,220.

Mel Is Thinking of Going on a Cruise