Question

Suppose terri has a​ 25% chance of becoming disabled in any given year. if she does become​ disabled, she will earn​ $0. if terri does not become​ disabled, she will earn her usual salary of​ $80,000. terri has the opportunity to purchase disability insurance for​ $20,000 which will pay her her full salary in the event she becomes disabled.​ terri's utility with the policy is​ _____ and her expected utility without the policy is​ _____.

Answer 1

Expected utility is calculated by multiplying the utility of each possible outcome by its probability and summing the products. So if Terri has a 25% chance of becoming disabled and purchases a policy then her expected utility is: (.25 x $20,000) + (.75 x $80,000) = $5,000 + $60,000 = $65,000. On the other hand, if Terri does not purchase a policy then her expected utility is (.25 x $0) + (.75 x $80,000) = $0 + $60,000 = $60,000.