John is deciding whether to exert effort (e = 1) to avoid an accident at work or not exert any effort (e =0). If e = 1, the probability of an accident is 0.5. If e = 0, the probability of an accident is 1. John'sincome without the accident is $100. In case of an accident, medical expenses will be $64. John utility ofincome is VI. The cost of effort, C(e), is 0 if effort is e = 0 and 1 if effort is e =is u(1, e) = VI – C(e).1. John's utility function(a) What are the expected utility values that John would face when he exerts effort and when hedoes not exert effort? Based on your calculations, should he exert effort? Briefly explain theintuition behind his decision in one or two sentences.Now suppose there is a risk neutral insurance company. Suppose the insurance company cannotmonitor whether John exerts effort or not. The insurance company considers two plan contracts.Contract Plan A:Premium: p = $36.Payout in the event of accident: d = $64Contract Plan B:Premium: p = $19.Payout in the event of accident: d = $32(b) For each plan contract, calculate John's final income in the event of no accident and in the eventof an accident occurs. It might be useful to list them in a table like this:Plan ContractIno accidentIaccidentАВWhich contract that provide consumption smoothing across two possible states of the world. Inother words, which contract provides the best overall insurance to John?(c) For each of these contracts, determine which of the two effort levels, e = 0 or e = 1, would beexpected utility maximizing for John if he decides to enroll in the plan contract. Assume that, ifboth effort levels yield the same expected utility, John will opt into effort level e = 1. Brieflyrelate vour answer to the concept of moral hazard.

A want satisfying power of a commodity or service is known as its utility. Utility is a significant…

John is deciding whether to exert effort (e = 1) to avoid an accident at work or not exert any effort (e = 0). If e1, the probability of an accident is 0.5. If e = 0, the probability of an accident is 1. John's income without the accident is $100. In case of an accident, medical expenses will be $64. John utility of income is VI. The cost of effort, C(e), is 0 if effort is e = 0 and 1 if effort is e = 1. John's utility function is u(I, e) = √-C(e). (a) What are the expected utility values that John would face when he exerts effort and when he does not exert effort? Based on your calculations, should he exert effort? Briefly explain the intuition behind his decision in one or two sentences. Now suppose there is a risk neutral insurance company. Suppose the insurance company cannot monitor whether John exerts effort or not. The insurance company considers two plan contracts. • Contract Plan A: о Premium: p = $36. ○ • Payout in the event of accident: d = $64 Contract Plan B: Premium: p $19. Payout in the event of accident: d = $32 (b) For each plan contract, calculate John's final income in the event of no accident and in the event of an accident occurs. It might be useful to list them in a table like this: Plan Contract Ino accident Iaccident A B Which contract that provide consumption smoothing across two possible states of the world. In other words, which contract provides the best overall insurance to John? (c) For each of these contracts, determine which of the two effort levels, e = 0 or e = 1, would be expected utility maximizing for John if he decides to enroll in the plan contract. Assume that, if both effort levels yield the same expected utility, John will opt into effort level e = 1. Briefly

12th Edition

ISBN:9781337517942

Author:NICHOLSON

Publisher:NICHOLSON

Chapter7: Uncertainty

Section: Chapter Questions

Problem 7.4P