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. Suppose that the price of the cruise is $1,200. If Mel is risk-neutral, then Mel should:

Question

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The expected value of the cruise without insurance is $1,220 (0.6 * $2,000 + 0.4 * $50). Mel should buy insurance if it costs less than the difference between this expected value and the cruise price, which is $780 ($2,000 - $1,220).

Mel Is Thinking of Going on a Cruise