Question

Kay has a set of jewellery consisting of pendant and earrings. Each piece of jewellery is worth $1,000 and the set is worth $2,000. She wants to send it to her sister, Helen, in Toronto. While she can send them free of charge, she is concerned about the safety of shipping them. She believes that the probability that the jewellery is lost in transit is 0.1. Both Kay and Helen are risk averse characterized by utility function, u（M ）=sqrt M , where M is their wealth levels.

1. a) Suppose Kay decides to send the two pieces of jewellery together. Compute Helen’s expected

   utility and illustrate your answer on a carefully labelled diagram.

2. b) Suppose that, in the event a single shipment is lost, this event would be independent of the outcome of any other shipment. Should Kay send the two pieces of jewellery together or separately? Explain your answer.

3. c) Suppose that Kay can purchase an insurance policy that reimburses her the full value in the event that the shipment is lost. What is her reservation price of this insurance policy? With an option of the insurance, does Kay choose to send her jewellery together or separately?

Answer 1