interpreting questions 2 and 3 on Problem Set #3

In question 2 of Problem Set 3, the loss in the FIRE state is $100, and $0 in the NO FIRE state. By “fully insuring” or purchasing “full coverage”, this means that you buy an insurance policy which pays off $100 if the FIRE state occurs and zero otherwise. I would also note that this question is based in large part upon the problem that is shown in Chapter 2 of Doherty (cf. pp. 29–32).

Finally, question 3 addresses how risk aversion changes with respect to increases in the level of initial wealth; as we saw during our last class meeting, diminishing marginal utility implies that the utility consequence of a given risk for a “rich” person is less severe than the utility consequence of such a risk for an otherwise identical “poor” person. We’ll develop this idea further during tomorrow’s class meeting by showing how individuals with larger initial wealth endowments behave in a less risk averse fashion than otherwise identical individuals who have smaller initial wealth endowments.

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