Term 2 week 2 choice under uncertainty insurance Flashcards
If there is a scenario in which a house could be robbed with chance 0.2 and in the bad state they have 500 pounds and in the good state they have 3750 how would you show this in lottery notation?
L = [3750 , 500 ; 0.8, 0.2]
What are the two types of insurance?
Actuarilly fair and actuarilly unfair
What is full insurance?
What does this do?
you insure for the difference between the good and the bad state.
Completely eliminates risk
What is actuarily fair insurance?
Price of insurance = probability of bad state occuring
What is the price of isurance?
cost of insurance / premium
How do you draw the risk function for risk averse in a lottery
X axis is expected wealth
Y axis is expected utility
draw concave utility and then straight line going through it
Draw the extremes of the expected wealth
lower bound of expected wealth maps 1 to 1 with concave function
Can insurance companies provide an actuarilly fair insurance?
No, as they would be at a loss.
Would a risk neutral person buy actuarilly unfair isurance?
No as the expected wealth is lower.
What dictates the level of insurance people buy?
Their preferences eg risk averse etcW
What are the different outcomes of events called?
Different states of nature
good state
bad state
How can we model preferences
What is the slope of the budget constraint in the insurance model?
How is this derived?
gamma / 1- gamma
When working out the insurance it is
3750 - gammaK
500+(1-gamma)K
The price of consumption in the bad state is the opportunity cost of not consuming in the good state = -gamma
The price of consumption in the good state is the opportunity cost of not consuming in the bad state. = (1-gamma)
How do you model which insurance bundle that individuals choose?
- You draw out the budget constraint which is in terms of gammas
-You then draw on the utility curves and then it optimises at a point which yields the highest utiity.
