Deck 11: Risk and Information in Contracts

Question 1

An insurer requiring a policyholder with a collision claim to submit more than one estimate of the repair costs is using a deductible to reduce morally hazardous behavior.

Answer 1

False

Question 2

Assume that the utility function of an individual is represented as U =√W - 0.001W; where W (his present wealth) = $250,000.He considers investing in a gamble which would double his wealth if he wins but still leave him with $250,000 if he loses.Given that his probability of winning is 0.6, calculate his expected wealth from the bet.

A)$300,000
B)$400,000
C)$250,000
D)$100,000

Answer 2

B

Question 3

An individual can avoid risks associated with a transaction by purchasing insurance.

Answer 3

True

Question 4

An insurance policy is a contract that:

A)benefits the parties if they have the same degrees of risk aversion.
B)benefits the parties if both of them are risk neutral.
C)benefits the parties if they have different degrees of risk aversion.
D)benefits the parties if either of them is risk neutral.

Question 5

Even if an insurance company holds a substantial reserve to pay claims, the algebra of probability shows that its funds are likely to be exhausted in payouts.

Question 6

If too many high risk policyholders migrate to a comprehensive health insurance plan which covers a wide range of treatments, the price of a policy must increase.

Question 7

Assume that the utility function of an individual is represented as U =√W - 0.001W; where W (his present wealth) = $250,000.He considers investing in a gamble which would double his wealth if he wins but still leave him with $250,000 if he loses.Given that his probability of winning is 0.6, calculate his expected utility of taking the bet.

A)157 units
B)250 units
C)207.11 units
D)224.3 units

Question 8

Insurers reduce the problem of moral hazard by limiting coverage of open-ended treatments like psychotherapy or fully elective treatments like some cosmetic surgeries.

Question 9

The problem of adverse selection is usually more acute in case of automobile insurance compared to health insurance.

Question 10

A buyer and a seller equally aware of market conditions enter into a contract to exchange a good at some date in the future.If the buyer benefits while the seller loses because the former anticipated the market price more accurately, the seller's loss can be attributed to asymmetric information.

Question 11

_____ is the price paid by the insured to sell the risk to the insurer, which must cover the expected payout if a disaster occurs.

A)Insurance interest
B)Insurance coverage
C)Insurance bonus
D)Insurance premium

Question 12

The lemons model suggests that owners will have superior information about the quality of their cars and incentives to conceal it, to which buyers will respond by lowering their bids.

Question 13

Asymmetric information increases the economic value that an agreement between two parties creates.

Question 14

An escalation or automatic adjustment provision in a purchase contract for some good deters opportunistic behavior and automatically reallocates risk as its price changes.

Question 15

Suppose a fashion designer wins a bid to design clothes for the characters of a movie.During his work he finds out that the payment he receives would not only cover his production costs but also earn him profits.The producer of the movie can be said to be facing a winner's curse.

Question 16

Suppose the seller of a used car provides unverifiable information about its quality to a prospective buyer.Unverifiability will reduce the cost of formulating a contract.

Question 17

Suppose the probability of a near-new car being good is 0.4 while its probability of being a lemon is 0.6.If risk-neutral consumers are willing to pay $14,000 if the car is in good condition and $8,000 if it is a lemon, a risk averse buyer who knows those probabilities would be willing to pay $10,400 for the car.

Question 18

Steve holds 100 shares of a company that currently trade at $10.There is a 50 percent probability of the market price increasing to $15 within the next quarter.If Steve waits for the market price of shares to increase before selling them off, he would be considered risk averse.

Question 19

An individual will be considered risk neutral if:

A)he is indifferent between taking and not taking up the gamble.
B)he pays someone to take away the gamble from him.
C)he pays someone to allow him to take the gamble.
D)he takes up the gamble under any situation.

Question 20

The parties to a contract will choose to acquire possibly duplicative information if they believe that the increase in economic value being created will exceed the cost of discovering the information.

Question 21

Suppose in the market for used cars, buyers would be willing to pay $9,000 for a car in good condition, while buyers would have to incur a cost of $3,500 to repair a car in poor condition.If the probability of a car being in bad condition is 0.35, what price would a risk-neutral buyer be willing to pay?

A)$3,925
B)$1,925
C)$7,775
D)$5,850

Question 22

If a purchase contract allows a buyer to accept less than a specified maximum "take" each month, buying a _____ would allow the seller to resell the excess at a _____ price.

A)put option; profitable
B)put option; predictable
C)call option; predictable
D)call option; profitable

Question 23

The problem of _____ can arise when a seller cannot obtain reliable information from buyers.

A)moral hazard
B)adverse selection
C)lemons problem
D)incomplete information

Question 24

Adverse selection can occur if:

A)high-risk persons insure themselves more heavily than low-risk persons.
B)high-risk persons claim coverage which cannot be borne by the insurers.
C)high-risk persons do not conceal information from the insurer.
D)high-risk persons make an effort to take less risk in the presence of an insurance cover.

Question 25

A contract containing an adjustment provision which allows the supplier to recover a fraction of his additional costs when input prices cross a certain level, is considered efficient because:

A)it reallocates the supplier's risk while checking his activities.
B)it reallocates risks completely to the buyers.
C)it allows the supplier to take up risks.
D)it allows the buyers to partially reallocate their risks.

Question 26

The effects of asymmetric information in the car market can be weakened by:

A)providing a warranty for the product.
B)purchasing business interruption insurance.
C)inserting a "buyer beware" clause in the agreement.
D)buying a "put" option.

Question 27

Assume that 50 percent of the population consisting of 2,000 low-risk people and 1,000 high-risk people choose a comprehensive health insurance plan having a break even premium of $800.The remaining 50 percent, also consisting of 2,000 low-risk people and 1,000 high-risk people, choose a Health Maintenance Organization plan having a break even premium of $400.If high-risk people submit claims worth $2,000 under the comprehensive plan and $1,000 under the HMO plan, which of the following situations will occur?

A)High-risk people will shift to the comprehensive plan resulting in an increase in its premium rate.
B)High-risk people will shift to the HMO plan resulting into a fall in its premium rate.
C)Low-risk people will shift to the comprehensive plan resulting in a substantial decrease in its premium rate.
D)Low-risk people in both groups will stick to their respective plans and minimize their losses.

Question 28

Suppose a comprehensive plan applies to 2,000 low-risk people and 1,000 high-risk people opting for insurance coverage.If the average claim submitted by low-risk people is $200 while that submitted by high-risk people is $2,000, what would be the net benefit accrued by a high-risk person paying the break even premium charged by the insurance company?

A)-$300
B)$1,800
C)$1,200
D)-$400

Question 29

People's abilities to bear risk increases with:

A)their abilities to understand the market.
B)their abilities to diversify their asset holdings.
C)their abilities to invest in risky assets over a large time period.
D)their abilities to judge the probability of outcomes.

Question 30

Suppose in the market for used cars, buyers would be willing to pay $9,000 for a car in good condition, while buyers would have to incur a cost of $3,500 to repair a car in poor condition.Assume a risk-averse buyer is aware that some of the cars are lemons, but is uninformed about the probability of a car being in good condition or otherwise.What price would this buyer, seeking only to minimize risk, be willing to pay for a car?

A)$3,925
B)$5,500
C)$7,775
D)$5,850

Question 31

Which of the following is a possible result of adverse selection?

A)Only lemons remain in the market for used cars.
B)A store manager shirks his responsibility because his supervisor is not present at all times.
C)A car mechanic does not bother to properly fix the customers' cars when his work cannot be monitored.
D)Many people selling their houses at very low prices expecting prices to decline further.

Question 32

Which of the following were discovered in a Federal Trade Commission Study of 8,000 new and used Corvettes sold on eBay between 2001 and 2003?

A)The last-minute bids on new Corvettes were higher than that on used ones.
B)The median winning bid on new Corvettes exceeded that on used ones.
C)The median winning bid on used Corvettes exceeded that on new ones.
D)The last-minute bids on used Corvettes were higher than that on new ones.

Question 33

The study conducted by Eric Bond of Vanderbilt University on the repair histories of a large sample of pickup trucks over three years old ascertained that:

A)the repair costs of trucks held by original users was similar to those held by second hand users.
B)the repair cost of trucks held by second hand users was higher compared to those held by original users.
C)the repair cost of trucks held by original users was higher compared to those held by second hand users.
D)the repair costs of trucks held by original users as well as those held by second hand users increased by the same magnitude every year.

Question 34

Which of the following is an example of incomplete information?

A)A seller losing out on profits because the market price rises above the pre-contracted price.
B)An insurer refuses to bear the complete cost of a treatment.
C)An insured car driver driving carelessly on the highway.
D)A new household appliance starts malfunctioning after two weeks.

Question 35

Which of the following risks will always be insured in a business?

A)Bad debts recorded in the company accounts
B)Vital inputs required for daily production
C)High-end technology based products
D)Inventory stocked up in the storehouses.

Question 36

Which of the following is an example of asymmetric information?

A)A student adopting unfair means to complete his/her assignment.
B)A commodity trader buying goods at a low price and selling them off at a high price.
C)A builder selling houses built on property that is zoned for industrial use.
D)A buyer paying a pre-contracted price which is lower than the current market price.

Question 37

Which of the following actions can prevent migration of individuals from one health insurance policy to another?

A)Lowering the opportunity costs of switching from one policy to another.
B)Fixing a uniform premium rate for all individuals under one type of policy.
C)Conducting an interview of the people before placing them under different policies.
D)Setting up a norm requiring all individuals to purchase the same coverage.

Question 38

Assume that a single insurance plan covers 2,000 low-risk people and 1,000 high-risk ones, all of whom pay the same premium, at which the insurer breaks even.If the average claim submitted by low-risk people is $100 while that submitted by high-risk people was $1,000, what would be the net benefit to a low-risk person from holding a policy?

A)-$300
B)-$250
C)$100
D)$500

Question 39

Which of the following can be a solution to the lemons problem?

A)Providing testimonials from previous buyers.
B)Providing accessories to be used in the car.
C)Providing discount on the purchase of a car.
D)Providing a warranty that covers the costs of certain repairs.

Question 40

Assume that a single insurance plan applies to 2,000 low-risk people and 1,000 high-risk people opting for insurance coverage.If the average claim submitted by low-risk people is $100 while that submitted by high-risk people was $1,000, the insurer would break even by setting a premium of:

A)$250.
B)$400.
C)$200.
D)$500.

Question 41

______ provisions in an insurance policy stipulate that it will pay only a certain percentage of losses claimed by the insured.

A)Vigilance
B)Co-payment
C)Non-price exception
D)Deductible

Question 42

Which of the following situations can lead to a winner's curse?

A)A bid which is won by multiple bidders but fails to cover the expectations of the seller.
B)A win which makes a player over-enthusiastic about further gambles.
C)An overoptimistic bid which helps the bidder to win but fails to cover his costs.
D)A win which makes the player risk-averse toward future gambles.

Question 43

The _____ clause in an insurance policy relieves the insurer of responsibility to pay for policyholder's losses below a pre-specified amount.

A)propitious selection
B)coinsurance
C)vigilance
D)deductible

Question 44

Which of the following is an example of a non-price provision in an automobile insurance contract that can reduce moral hazard?

A)A provision specifying that coverage is limited to 75 percent of the total damages caused by an accident.
B)A provision that disallows medical claims by drunk drivers involved in accidents.
C)A provision that restricts accident compensation to claims over $1,000.
D)A provision requiring that the insured car carry certain safety devices like air bags.

Question 45

Which of the following practices of insurers deter moral hazard?

A)Setting a uniform premium structure.
B)Requiring people to purchase the same coverage.
C)Arranging for reinsurance to cut the risk of unexpectedly large claims.
D)Conducting security checks without notice and terminating the policy whenever required.

Question 46

According to the theory of propitious selection:

A)risk-neutral people are more likely to opt for insurance coverage.
B)risk-averse people are more likely to opt for insurance coverage.
C)high-risk people submit large claims for insurance coverage.
D)high-risk people submit smaller claims for insurance coverage.

Question 47

Which of following provisions in an insurance policy may be economically efficient if policy holders can control small claims but not large ones?

A)Vigilance provision
B)Non-price exceptions
C)Co-payment provisions
D)Liquidated damages

Question 48

How is the utility of a gamble to a risk averse person different from that to a risk neutral person?

Question 49

_____ refers to the situation faced by an insurance plan whose costs steadily increase as worse risks migrate toward it and better risks migrate away.

A)Adverse selection
B)Lemons problem
C)Moral hazard
D)Death spiral

Question 50

When does an insurance contract benefit both the parties?

Question 51

What is an insurance premium?

Question 52

DTC contracts which prohibit buyers from inspecting diamonds in advance help to minimize:

A)the problem of moral hazard.
B)the cost of gathering duplicative information.
C)the problem of adverse selection.
D)the winner's curse.

Question 53

What are the disadvantages of a standard form contract?

Question 54

Which of the following is an example of a moral hazard?

A)A student committing suicide after failing in an examination.
B)A housekeeper leaving a house unlocked after insuring it against burglary.
C)An exporter delivering faulty products after receiving a certain fraction of the total payment.
D)A person deriving utility from a commodity without paying for it.

Question 55

In a principal/agent relationship, _____ can help to reduce the damage caused by a winner's curse, provided both the parties are well-informed.

A)signals
B)warranties
C)disclosure
D)renegotiation

Question 56

Which of the following theories states that people who are highly risk-averse are less likely to engage in high-risk activities?

A)The theory of moral hazard
B)The theory of adverse selection
C)The propitious selection theory
D)The death spiral theory

Question 57

Which of the following problems associated with asymmetric information can be avoided by using a product warranty?

A)Lemons problem
B)Problem of adverse selection
C)Moral Hazard
D)Problem of blind sight

Question 58

Which of the following can be a signal of product quality to customers?

A)Discounts offered on bulk purchases of the product.
B)Gift of complementary products offered to purchasers.
C)The information provided by the salesperson about the product.
D)A warranty provided along with the product.

Question 59

An insured person's incentive to behave in ways that raise the probability of a claim is known as:

A)a moral hazard.
B)the lemons problem.
C)the problem of adverse selection.
D)the problem of advantageous selection.

Question 60

What is the difference between the utility function of a risk averse person and a risk neutral person.

Question 61

Explain the difference between adverse selection and moral hazard?

Question 62

Mention some of ways in which insurers control the problem of moral hazard.

Question 63

What is asymmetric information? Describe with examples.

Question 64

Mention some of the ways in which the problem of asymmetric information can be reduced.

Question 65

How does asymmetric information affect a contract?

Question 66

When is disclosure economically desirable?

Question 67

When does the problem of adverse selection arise in any market?