Exam 19: Uncertainty, Risk, and Private Information

As a result of frequent flooding, the insurance market has noted a positive correlation between flooding and the amount of insurance monies paid out for such floods. Moreover, the probability of such flooding has been increasing. As a result, homeowners in flood plains will find flood insurance:

Adverse selection and moral hazard do not affect the efficiency of the market.

The future price of one share of General Motors stock is a random variable.

In practice, insurance companies faced with adverse selection use _____ to deal with it.

An efficient market for risk, such as an insurance market, is most likely to exist:

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 $1,000 the Ramirez family can buy insurance that will cover the full cost of repairs. If family members are risk-averse and want to maximize their expected utility:

Individuals differ in risk aversion because of:

Private information can cause economic inefficiency by preventing mutually beneficial transactions.

You insure your car against theft. Consequently, you rarely lock the car. This describes the problem of:

Two possible events are independent if they happen at different times and in different places.

Use the following to answer questions -(Table: Natasha's Total Utility) Look at the table Natasha's Total Utility. Natasha earns $50,000 per year but faces losing $20,000 of it if she is late with her work. If there is a 25% probability that Natasha will be late with her work and her income will then equal $30,000, her expected income is:

Use the following to answer questions : -(Table: Utility for Terri and Mary) Look at the table Utility for Terri and Mary. Each has an income of $300. If each were offered insurance to offset the risk of falling income, _____ would pay a larger premium because she is the consumer with _____ risk aversion.

Moral hazard can be reduced by:

You are about to have a meeting with your manager about a raise in your salary. You are going to request an increase of $5,000, but you believe the probability of success to be only 25%. You believe there is a 25% probability your boss will counter with a $3,000 raise and a 25% probability that your boss will offer a $1,000 raise. Finally, there is a 25% probability that you will receive no increase in your salary. What is the expected value of the outcome of your meeting?

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 premium for a fair insurance policy to pay their daughter's tuition and eliminate the uncertainty in the Smith family's income after tuition would equal:

The expected value of a random variable is:

As the premium for an insurance policy rises, there is a(n) _____ in the _____ insurance.

When faced with an insurance policy whose premium exceeds the expected value of the claim:

Risk-averse individuals:

A fair insurance policy is one whose premium is _____ the expected value of the claims.