Question

Consider the decision to purchase health insurance. Imagine that there are three states of the world: you are in good health and spend $0 on healthcare, you are in fair health and spend $100 on healthcare, or you are in poor health and spend $10,000 on healthcare. The probability that you are in good health is .20, the probability you are in fair health is .75, and the probability that you are in poor health is .05. During open enrollment, you have to decide whether or not to buy insurance that will cover you next year. If you buy insurance, you are fully insured and will pay nothing for healthcare, regardless of your spending. Assume that there is no correlation between your current health and your future health. (Part A) If you have utility u ( c ) = c, what is the maximum you would be willing to pay for health insurance for the coming year? I said $575 but would like to make sure

Answer 1

Maximum amount I would be willing to pay would be equal to probability multiplied by expenditure, i.e. P(good health)× expenditure+P(fair health)×expenditure +P(poor health)×expenditure= 0.2×$0+0.75×$100+0.05×$10000= $575.