Diminishing marginal utility will demand insurance

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A person with diminishing marginal utility will demand insurance (i.e., will be willing to pay more to get insurance than (the negative of) the expected value of the loss lottery). Try to replicate our example of full insurance with an individual who is loss averse. That is, assume the utility function over outcomes u(x) is x everywhere above the reference point q and is 3x everywhere below the reference point q. Assume the person has an initial wealth w and might incur a loss L. The probability with which the loss occurs is p. Insurance premium is r. What do you have to believe about the individual's reference point q so that the insurance example works - i.e., so that the individual is willing to pay more for full insurance than (the negative of) the expected value of the loss lottery?

Reference no: EM131094733

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