Consider a medieval Italian merchant who is a risk averse expected utility maximiser. Their wealth will be equal to y if their ship returns safely from Asia loaded with the finest silk. If the ship sinks, their income will be y − L. The chance of a safe return is 50%. (i) Draw and carefully label the merchant’s endowment point, their expected income, and their cer- tainty equivalent income in a 2-dimensional state-contingent consumption space. (ii) Use the diagram to illustrate and explain how the merchant would benefit from buying insurance in a competitive insurance market. At which point a risk-neutral insurance firm would maximise their profits by offering the merchant full insurance?
Question 3
Consider a medieval Italian merchant who is a risk averse expected utility maximiser. Their wealth will be equal to y if their ship returns safely from Asia loaded with the finest silk. If the ship sinks, their income will be y − L. The chance of a safe return is 50%.
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(i) Draw and carefully label the merchant’s endowment point, their expected income, and their cer- tainty equivalent income in a 2-dimensional state-contingent consumption space.
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(ii) Use the diagram to illustrate and explain how the merchant would benefit from buying insurance in a competitive insurance market. At which point a risk-neutral insurance firm would maximise their profits by offering the merchant full insurance?
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