Exam 19: Uncertainty, Risk, and Private Information

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:

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. Mr. and Mrs. Smith would be willing to pay as much as _____ for insurance to pay their daughter's tuition and eliminate the uncertainty in the family's income after tuition.

_____ of insurance are often risk-averse, and _____ of insurance are interested in reducing their exposure to risk.

A random variable:

Moral hazard occurs only when people fail to do what is in their best interest.

Use the following to answer questions Scenario: Buying Shares Geordie is considering buying shares in two companies, Apple and Microsoft. If he invests $1,000 in Apple, there is a 40% probability that his investment will be worth only $800 and a 60% probability that it will be worth $1,200 at the end of a year. If he invests $500 in Apple, there is a 40% probability that his investment will be worth $400 and a 60% probability that it will be worth $600 at the end of a year. The corresponding numbers for investment in Microsoft are identical. -(Scenario: Buying Shares) Look at the scenario Buying Shares. The probability that Geordie will sustain a loss is _____ if he invests $1,000 in either Apple or Microsoft and is _____ if he invests $500 apiece in Apple and in Microsoft.

Louis has invested $1,000 in the stock market. At the end of one year, there is a 30% chance that his stock will be worth only $800 and a 70% chance that it will be worth $1,200. The expected value of his stock at the end of one year is:

Use the following to answer questions Figure: Differences in Risk Aversion -(Figure: Differences in Risk Aversion) Look at the figure Differences in Risk Aversion. Which of the following statements is CORRECT?

Two consumers go to the insurance company to purchase life insurance. James is a smoker and a police officer who races motorcycles in his spare time. Kathy is a nonsmoker and a librarian who likes to make quilts in her spare time. The insurance company knows that both consumers are 40 years old, but the company has no information about occupations or hobbies. How does the private information in this situation set up an adverse-selection problem? How could the insurance company lessen this problem?

Use the following to answer questions Figure: Differences in Risk Aversion -(Figure: Differences in Risk Aversion) Look at the figure Differences in Risk Aversion. An important reason Ernest and Salvatore may differ in their aversion to risk is:

Moral hazard occurs when individuals:

Use the following to answer questions : -(Table: Choice with Uncertainty) Look at the table Choice with Uncertainty. Suppose the probability that the sitcom does not make it to television is 30%, that it makes it to television but is not the most viewed show in its time slot is 50%, and that it makes it to television and is the most viewed show in its time slot is 20%. Given this information, Norman's expected income is:

People who want to reduce the risk they face may pay other people who are less sensitive to risk to take on some of their risk. As a result:

Use the following to answer questions Scenario: Buying Shares Geordie is considering buying shares in two companies, Apple and Microsoft. If he invests $1,000 in Apple, there is a 40% probability that his investment will be worth only $800 and a 60% probability that it will be worth $1,200 at the end of a year. If he invests $500 in Apple, there is a 40% probability that his investment will be worth $400 and a 60% probability that it will be worth $600 at the end of a year. The corresponding numbers for investment in Microsoft are identical. -(Scenario: Buying Shares) Look at the scenario Buying Shares. The probability that Geordie will make a gain is _____ if he invests $1,000 in either Apple or Microsoft. The probability that he will make a gain is _____ if he invests $500 apiece in Apple and in Microsoft.

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. If buyers cannot distinguish between lemons and plums, eventually this used car market will:

You have one ticket for a raffle with a grand prize of $1,000. There are two prizes worth $100 and five prizes worth $20. If only 100 tickets have been distributed, what is the expected value of your winnings?

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. Whitney's expected utility is _____ utils.

Use the following to answer questions Scenario: Flood Area Suppose you own a home that is estimated to be worth $250,000. You live in a flood plain; as a result, the probability that you will lose your home to a flood is 30%. -(Scenario: Flood Area) Look at the scenario Flood Area. A flood may occur, causing you to lose your entire home. In this case, your expected loss resulting from the flood would be:

Use the following to answer questions : -(Table: Income and Utility for Tyler) The table Income and Utility for Tyler shows the utility Tyler receives at various income levels, but she does not know what her income will be next year. There is a 40% chance her income will be $20,000, a 40% chance her income will be $30,000, and a 20% chance her income will be $40,000. What level of certain income matches her expected utility, given the uncertainty?

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, what is his expected gain or loss?