Exam 20: Uncertainty and Information

Consider a market for used cars. Suppose there are only two kinds of cars: lemons and good cars. A lemon is worth $1,500 both to its current owner and to anyone who buys it. A good car is worth $6,000 to its current and potential owners. Buyers can't tell whether a car is a lemon until after they have bought the car. What do economists call the problem that buyers of used cars face? What kind of cars (lemons, good cars, or both) are traded? Explain and substantiate your answer.

-Adriana wants to try working as an independent contractor this summer. She has a 50 percent chance that she will make $9,000 and 50 percent chance that she will make nothing. Her utility of wealth curve is shown in the figure above. What's Adriana's cost of risk?

-Larry owns a car worth $20,000, and that is his only wealth. There is a 10 percent chance that Larry will have an accident within a year. If he does have an accident, his car is worthless. Larry's utility of wealth curve is shown in the figure above. An insurance company agrees to pay a car owner like Larry the full value of his car in case of an accident if the car owner buys the company's insurance policy. The company's operating expenses are $2,500 per policy. a) What is Larry's expected wealth? b) What is Larry's expected utility? c) What is the maximum amount that Larry is willing to pay for car insurance? d) What is the minimum premium that the insurance company is willing to accept? e) Will Larry buy the insurance policy? Why or why not?

There is a growing market for buying and selling information about the online behavior of consumers. Most people use one of only a small number of search engines (such as Google, Bing, or Yahoo!) when surfing the net. It has been hard for new search engines to gain any market share. The market for search is best considered as

Katy has an ailing and wealthy, but miserly, parent. The parent has told Katy that if she takes care of him until he dies, then she will get $100,000 in inheritance. Katy knows that there is only a 50-50 chance that her father will leave her the full amount or nothing. To take care of her father, she has to quit her job that pays $60,000 where per year. If her father is expected to pass away in 1 year, what is Katy's expected wealth if she takes care of her father?

The used car market without warranties suffers from

-Steve owns a motorcycle valued at $5,000 and that is his only asset. There is a 5 percent chance that Steve will have an accident within a year. If he does have an accident, his motorcycle is worthless. Steve's utility of wealth curve is shown in the figure above. An insurance company agrees to pay Steve the full value of his motorcycle in case of an accident if he buys the company's insurance policy. The company's operating expenses are $500 per policy. What is the minimum premium that the insurance company will accept?

Moral hazard occurs when an agreement encourages undesirable behavior.

-Roy owns a sports car worth $40,000, and that is his only wealth. Roy is a reckless driver, and there is a 30 percent chance that he will have an accident within a year. If he does have an accident, his car is worthless. Roy's utility of wealth curve is shown in the figure below. An insurance company agrees to pay a car owner like Roy the full value of his car in case of an accident if the car owner buys the company's insurance policy. The company's operating expenses are $2,000 per policy. a) What is Roy's expected wealth? b) What is Roy's expected utility? c) What is the maximum amount that Roy is willing to pay for car insurance? d) What is the minimum premium that the insurance company is willing to accept? e) Will Roy buy the insurance policy? Why or why not?

In an ad for insurance, the text reads "Life's an adventure, and there are plenty of perils awaiting your jewelry: a lost or broken stone, theft, accidental loss, damage, mysterious disappearance Have you thought about insurance?" How does the inclusion of accidental loss and mysterious disappearance create adverse selection?

An increase in Meta's wealth from $3,000 to $6,000 raises her utility from 80 units to 100 units. If she is risk averse, with a wealth of $9,000 her utility might be

Pedro's utility of wealth is 6 units for $10,000 and 10 units for $20,000. A friend gave him a lottery ticket for his birthday. The ticket won, giving him either $10,000 with probability 0.5 or $20,000 with probability 0.5. Pedro's expected utility from the lottery ticket is

-Beachcomber Beatrice spent her entire wealth of $100,000 to build a beach house on the Gulf of Mexico. There is a 10 percent chance that the house will be totally destroyed by a hurricane. Beatrice's utility of wealth schedule is given in the table above. What is the minimum amount that the insurance company would require Beatrice to pay for an insurance policy that pays $100,000 if her beach house is destroyed by a hurricane? (Assume the insurance company has no other costs.)

Insurance companies

-Andrew has the utility of wealth curve shown in the above figure. He owns an SUV worth $30,000, and that is his only wealth. There is a 10 percent chance that he will have an accident within a year. If he does have an accident, his SUV is worthless. The value of insurance to Andrew against an accident is

-Bobby is offered two fulltime jobs. In the first job, as a salesperson, he has a 50 percent chance to make $2,000 a month and a 50 percent chance to make $10,000 a month. The second job, as a construction worker, pays $4,500 a month with certainty. Bobby's utility of wealth curve is shown in the figure above. Bobby will take the ________ job because his expected ________ from this job is greater.

If an individual has a 0.3 probability of receiving $10 and a 0.7 probability of receiving $20, the expected income is

If Ben becomes less likely to buy smoke detectors after he has fire insurance, he is illustrating

-Andrew's utility of wealth schedule is given in the above table. Andrew is offered a job as a cook which pays $10,000. He is also offered a job as a server which will pay $5,000 if tips are poor and $15,000 if tips are good. There is a 50 percent chance that tips will be poor and a 50 percent chance that tips will be good. The expected income from the job as a cook is ________ and from the job as a server is ________.

Mel's utility of wealth is 130 units at $3,000, 160 units at $5,000, and 190 units at $9,000. Starting from zero wealth, he must choose between options A and B. Option A gives him $5,000 for sure. Option B gives him $3,000 with probability 0.4 or $9,000 with probability 0.6. Mel