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Exercise Lecture 10

Intermediate Micro

Exercise 1.(Adapted from exercise 8.12 in F. Cowells book ) A risk-averse person has wealth
W and faces a risk of loss L < W with probability . An insurance company oers cover of
the loss at a premium K such that L > K > L. It is possible to take out partial cover on
a pro-rata basis, so that amount tL of the loss can be covered at cost tK, where 0 < t < 1.
We assume that the persons cardinal utility function u is twice dierentiable.
1. Write down the expression for the persons expected utility E[u(x)].
2. Find the condition that will determine t , the optimal value of t.
3. Explain why the person will not choose full insurance.
4. Assume that u(x) = ln(x), show how t will change as W increases (if all other parameters remain unchanged).