Exam 20: Uncertainty, Risk, and Private Information

Use the following to answer questions: -(Table: Income and Utility for Whitney) Look at the table Income and Utility for Whitney. Whitney's income next year is uncertain: there is a 40% probability she will make $40,000 and a 60% probability she will make $80,000. What certain income leaves Whitney as well off as her uncertain income?

Domingo has total wealth of $500,000 composed of a house worth $100,000 and $400,000 in cash. He keeps the cash in a safe deposit box, so that it is completely safe. However, there is a 10% chance that his house will burn down and be worth nothing and a 90% chance that nothing will happen to it. Domingo buys insurance guaranteeing that his house will be restored to its original condition should anything happen to it. The insurance premium is $2,000. Consequently (assuming other things remain unchanged), his future:

If the probability that one person will develop a health problem is greater than that of another person and if they buy insurance from the same provider, most likely the person with a higher probability will pay:

The existence of a large and growing gambling industry clearly shows that many people are risk-loving.

The seller of a product will sometimes offer a warranty that if the product is defective, the seller will repair or replace it free of charge within a specified time. What is the role of product warranties in lessening the problem of asymmetric information (or private information) and increasing the number of transactions that are made?

The strategy of reducing or eliminating risks by taking a small share in many independent events or by taking advantage of the predictability associated with large numbers of independent events is known as:

Use the following to answer questions: Scenario: Diversification Morris is considering investing $10,000 in a sunglass company or a rain poncho company. If it is a rainy year and he invests only in the sunglass company, he will lose $5,000. However, if it is a rainy year and he invests only in the rain poncho company, he will earn $10,000. If it is a sunny year and he invests only in the sunglass company, he will earn $10,000; if he invests only in the rain poncho company, he will lose $5,000 in a sunny year. There is a 50% chance of a sunny year and a 50% chance of a rainy year. -(Scenario: Diversification) Look at the scenario Diversification. If Morris invests half of his money in the sunglass company and half in the rain poncho company, he will earn _____ in a sunny year and _____ in a rainy year.

The marginal utility of income for a risk-averse individual will be:

Insurance companies attempt to minimize moral hazard by imposing:

Suppose the probability of a major theft at a hotel is 1%, while the probability of an earthquake hitting the hotel is 2.3%. The probability that both would occur on the same day is therefore:

Use the following to answer questions: -(Table: Total Utility of Income After College Expenses) Look at the table Total Utility of Income After College Expenses. The Smith family has _____ marginal utility as income increases. The marginal utility of income between $32,500 and $35,000 is _____ utils per dollar, while it is _____ utils per dollar between $45,000 and $47,500.

Organized-gambling venues such as those at Las Vegas tend to attract:

Use the following to answer questions: Scenario: Used Car Market In the used car market, cars of poor quality are called lemons, while cars of good quality are plums. Suppose the probability of obtaining a lemon is 60% and the probability of obtaining a plum is 40%. Also assume a plum is worth $15,000 and a lemon is worth $3,000. -(Scenario: Used Car Market) Look at the scenario Used Car Market. The expected value of a used car is:

Asymmetric, or private, information:

In which of the following situations is adverse selection most likely to be a problem?

Use the following to answer questions: Scenario: Choosing Insurance The Ramirez family owns three cars and is considering buying insurance to cover the cost of repairs. They face two possible states: in state 1 their cars need no repairs and their income available for purchasing other goods and services is $50,000; in state 2 their cars need $10,000 worth of repairs and their income available for purchasing other goods and services is reduced to $40,000. The probability of repairs is 10%, while the probability of no repairs is 90%. -(Scenario: Choosing Insurance) Refer to the information in the scenario Choosing Insurance. For $900 the Ramirez family can buy insurance that will cover the full cost of repairs. If family members are risk-averse and maximize their expected utility:

The easiest risks to reduce by diversification are those associated with positively correlated events.

Newman has decided to take a road trip in a rental car. He has the minimum amount of personal car insurance to rent the car, but he decides to pay a little extra to the rental car company to completely insure himself against any damage to the rental car. How is there a potential moral hazard due to Newman's purchase of the additional insurance?

Insurance premiums often fall substantially if a buyer purchases a policy with a high deductible, and such a policy is often purchased by individuals who self-identify as:

Solutions to moral hazard include: