Exercise 5: Insurance Consider two individuals, Dave and Eva. Both Dave and Eva have initial wealth 810; 000 and face a 40% chance of losing L = 450; 000. Dave has von Neumann-Morgenstern utility function uD(x) = x and Eva has von Neumann-Morgenstern utility function uE(x) = p x. 1. What do you know about Dave's and Eva's risk preferences? 2. What is the most Dave would be willing to pay for complete insurance against the loss? 3. What is the most Eva would be willing to pay for complete insurance against the loss? Suppose they are each able to choose insurance with any coverage level z 2 [0; 1] (i. e. 0 z 1). If an individual buys insurance coverage at level z, they will get reimbursed 450; 000z if the loss occurs. Insurance coverage at level z costs c(z) = z 200; 000. 4. What coverage level zD would Dave choose? Explain. 5. Based on your previous results, try to explain that Eva chooses a strictly positive coverage zE > 0. 6. Is Eva's optimal choice full insurance, i. e. zE = 1? ECON