Why do people typically purchase insurance policies in the context of consumer surplus and willingness to pay?

• A. To maximize their consumer surplus by always paying less than their willingness to pay
• B. To reduce the risk of large financial losses and increase their expected utility
• C. To avoid paying any out-of-pocket expenses for goods and services
• D. To guarantee a profit from uncertain events

Answer: (B)

Verified step by step guidance

1. Step 1: Understand the concept of consumer surplus, which is the difference between what a consumer is willing to pay for a good or service and what they actually pay. It represents the net benefit or utility gained from a purchase.
2. Step 2: Recognize that insurance is a financial product designed to protect individuals from uncertain, potentially large losses by transferring risk to an insurer in exchange for a premium.
3. Step 3: Analyze how risk aversion affects willingness to pay. Consumers often prefer to pay a certain, smaller amount (the insurance premium) rather than face the possibility of a large, uncertain loss, even if the expected monetary value might be the same or slightly less.
4. Step 4: Connect this behavior to expected utility theory, where consumers maximize their expected utility rather than expected monetary value. Insurance increases expected utility by reducing the variability of outcomes and providing financial security.
5. Step 5: Conclude that people purchase insurance not to maximize consumer surplus in the traditional sense of paying less than their willingness to pay, but to reduce risk and increase their expected utility, which aligns with the correct answer.