The town of Cross Plains lies in a peculiar location where one side of the town (the
Question:
The town of Cross Plains lies in a peculiar location where one side of the town (the West Side) is immune from floods while the other side (yes, the East Side) is hit randomly by heavy flooding when the Black Earth Creek overflows its banks every few years. Historically houses on the West Side never deteriorate, while houses on the East Side are destroyed completely each year with .02% probability. Floods are not typically fatal, but on average 10% cause a fatality. A typical house on the safe West Side sells for $150,000. A comparable house on the East Side sells for $125,000 and can be replaced quickly for $150,000. The real interest rate is 2.5% a year
(a) Assuming that residents of San Wobble are risk neutral with regard to loss of property, what is the value that they place on loss of life?
(b) If instead you knew from some other source that they value their lives at $7 million, how would the certainty equivalent of the loss of property value from a storm compare to his expected value? Are residents risk averse or risk loving?
Expert Answer:
a To find the value that residents of San Wobble place on loss of life we can use the concept of exp... View the full answer
