Suppose an individual has the following utility function defined over wealth: U = U (wealth under square root). The individual has an initial wealth level of $20,000. Initially, the individual has a 20% chance of a heart attack and the loss associated with the attack is $5000. A new drug has been developed that is effective in preventing heart attacks. Taking the drug reduces the chance of a heart attack to 10%, but the loss associated with the attack increases to $10,000.
a. Now what is the expected loss?
b. What is the maximum amount this individual is willing to pay for insurance against a heart attack?
c. What is the risk premium?
d. What is the welfare gain from the insurance? Draw a diagram and label the welfare gain.