Answer Happy

2. Charlie has wealth (a house and land) of $360,000. Every summer, however, there is a 10% chance that Charlie's house will be blown away by a tornado, leaving him with just the land that the house stands on. This land alone is worth just $40,000. Charlie has a von Neumann-Morgenstern utility function, with the scaling function V = In(W), where W is Charlie's wealth. An insurance co-operative offers to sell tornado insurance to Char- lie at a cost of $0.25 for each dollar of insurance purchased. He can also sell insurance as part of the cooperative to other farmers at this same cost. = (a) Write an equation for Charlie's budget line, the set of just affordable wealth is there is or is not a tornado, with the purchase of insurance. (b) With the purchase or insurance, what will Charlie's wealth be if there is a tornado and if there is no tornado? How much insurance will he buy? How much will he be paid (gross) if there is a tornado? Graph his budget line, endowment, and optimal choice, including the indifference curve through his endowment and optimal choice.