Chapter12UncertaintyKeyConceptcontingentconsumption.pptVIP

Fig. 12.2 Fig. 12.3 Go back to the insurance example. Assume a risk averse expected utility maximizer. Then 1) on an indifference curve, when c1 is greater, c2 has to lower. 2) |MRS12|=MU1/MU2=?1v’(c1)/?2v’(c2), since v() is concave, when c1 is greater and c2 is lower, then v’(c1)/v’(c2) is lower and hence |MRS12| is smaller. So we have the usual (convex to the origin) indifference curves. If insurance is fair, i.e. r=1-p, then at optimum, it must be |MRS12|=pv’(c1)/[(1-p)v’(c2)]=(1-r)/r. So v’(c1)=v’(c2) or c1=c2. This means, in words, facing a fair insurance, a risk averse, expecte