week 11 B - COMM 295 November 18, 2010 Decision Making with...

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COMM 295 November 18, 2010 Decision Making with Uncertainty: Part 2
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Topics • Insurance • Diversification • Behavioural peculiarities • Prospect theory
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Risk Aversion
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Insurance Example • Suppose U(X) = X 0.5 • You face a 10% chance of disability • Income with & without disability is 1 & 9 • Disability insurance pays you 8 in the event of an accident (brings income to 9) • Insurance company expects to pay you: Expected Claim = 0.1(8) = 0.8 • What are you willing to pay for insurance?
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Insurance Example, Cont’n Risk Neutral Person • Let C be cost of insurance • Without insurance, expected income is 0.9(9) + 0.1(1) = 8.2 • With insurance (guaranteed income = 9) expected income = 9 – C • Most a risk-neutral will pay for insurance is C RN = 0.8 (obtained by solving 9 – C = 8.2) • Notice that C RN = Expected Claim
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Risk Averse Person • Without insurance, a risk averse person has expected utility: .9(9 .5 ) + .1(1 .5 ) • With insurance (guarantees income = 9) expected utility is (9– C) .5 • Indifferent when C = 1.16 because
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This note was uploaded on 01/03/2011 for the course COMM 290 taught by Professor Brian during the Winter '09 term at The University of British Columbia.

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week 11 B - COMM 295 November 18, 2010 Decision Making with...

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