Question 1

-Van, whose utility of wealth curve is shown in the above figure, owns a home that is valued at $100,000. There is a 10 percent chance that the house will be destroyed by hurricane. The value of insurance to Van is

Accepted Answer

A)  $10,000. 
B)  $15,000. 
C)  $20,000. 
D)  $30,000.

Question 2

Suppose Nara could invest her $1000 in a savings account or she could invest in the stock market. After one year, the savings account has a guaranteed 5 percent interest rate and the stock market has a 10 percent chance of tripling her money, and 90 percent chance of losing it all. To give Nara the maximum expected wealth, what should she do?

Accepted Answer

A)  She should invest all of her money in the stock market. 
B)  She should invest all of her money in the savings account. 
C)  She should invest half of her money in the savings account and half in the stock market. 
D)  She should only invest her money in the stock market if she is risk averse.

Question 3

Adverse selection can occur when

Accepted Answer

A)  all parties have full information. 
B)  one party has information not available to the other party. 
C)  incentives result in one party not reaching an agreement with the other party. 
D)  nobody has any information.

Question 4

-John's utility of wealth curve is shown in the above figure. He currently has total wealth of $20,000. If there is a 50 percent chance that his $10,000 car will be stolen, what is the value of insurance against the theft?

Accepted Answer

A)  $0 
B)  $5,000 
C)  $7,000 
D)  $13,000

Question 5

Moral hazard typically occurs because

Accepted Answer

A)  people are dishonest. 
B)  agreements sometimes create incentives that are costly to monitor. 
C)  workers possess diminishing marginal productivity. 
D)  workers possess adverse selection.

Question 6

-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 ________.

Accepted Answer

A)  $10,000; $15,000 
B)  $5,000; $5,000 
C)  $10,000; $5,000 
D)  $10,000; $10,000

Question 7

-Ashton has the utility of wealth curve shown in the above figure. He owns a sports car worth $30,000, and that is his only wealth. Ashton is a careless 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. What is Ashton's expected wealth?

Accepted Answer

A)  $30,000 
B)  $9,000 
C)  $21,000 
D)  zero

Question 8

You took a job as a salesperson in an insurance company with the knowledge that you have 0.5 chance of making $2,000 a month or $3,000 a month. How much will you make each month?

Accepted Answer

A)  definitely $2,500 
B)  definitely $2,000 
C)  definitely $3,000 
D)  either $2,000 or $3,000

Question 9

Insurance works by

Accepted Answer

A)  eliminating risks. 
B)  decreasing risks. 
C)  pooling risks. 
D)  changing the individual's marginal utility of wealth.

Question 10

-James has a utility of wealth schedule in the above table. He is offered a job selling video games at Games Galore. James' compensation depends on how much he sells. In a poor sales period, a salesperson makes $100 per month. In a good sales period, a salesperson makes $600 per month. James is told by the manager that, in any given month, there is a 25 percent chance of a poor sales period and a 75 percent chance of a good sales period. Suppose that one of James' professors offers him the opportunity to be a research assistant for a fixed and guaranteed amount each month. What amount must James' professor pay in order to make James indifferent between being a research assistant and working at Games Galore?

Accepted Answer

A)  $300 per month 
B)  $350 per month 
C)  $475 per month 
D)  $600 per month

Question 11

Nicole is indifferent between option A, which gives her $20,000 for sure, and option B, which gives her $10,000 with probability 0.5 or $32,000 with probability 0.5. Nicole's cost of risk for option B is

Accepted Answer

A)  zero. 
B)  $1,000. 
C)  $2,000. 
D)  $20,000.

Question 12

For a risk-averse individual, as wealth increases, total utility

Accepted Answer

A)  increases at a decreasing rate. 
B)  increases at a constant rate. 
C)  increases at an increasing rate. 
D)  is constant.

Question 13

Pablo must choose among options A, B, and C. Option A gives him $10,000 for sure. Option B gives him $4,000 with probability 0.5 or $16,000 with probability 0.5. Option C gives him $8,000 with probability 0.5 or $12,000 with probability 0.5. If he receives diminishing marginal utility from wealth, Pablo will

Accepted Answer

A)  choose option A. 
B)  choose option B. 
C)  choose option C. 
D)  be indifferent among options A, B, and C.

Question 14

Travel insurance (which pays a traveler if the traveler needs to cancel his or her trip) has a clause that states it will not pay if the trip is cancelled because of a pre-existing condition. If sick people are more likely to purchase travel insurance, this clause is meant to

Accepted Answer

A)  reduce moral hazard. 
B)  reduce adverse selection. 
C)  increase moral hazard. 
D)  increase adverse selection.

Question 15

Moral hazard results from ________ information and adverse selection results from ________ information.

Accepted Answer

A)  private; private 
B)  private; public 
C)  public; private 
D)  public; public

Question 16

Christy is a telemarketer. She estimates that this summer, she has a 0.2 probability of earning $10,000, a 0.5 probability of earning $5,000, and a 0.3 probability of earning only $1,000. What is Christy's expected income?

Accepted Answer

A)  $7,256 
B)  $5,333 
C)  $4,800 
D)  $4,000

Question 17

One way of reducing the moral hazard problem in the automobile insurance market is for drivers to

Accepted Answer

A)  carry high deductibles. 
B)  carry no deductibles. 
C)  all have good driving records. 
D)  never make any claims.

Question 18

-James has a utility of wealth schedule in the above table. He is offered a job selling video games at Games Galore. James' compensation depends on how much he sells. In a poor sales period, a salesperson makes $100 per month. In a good sales period, a salesperson makes $600 per month. James is told by the manager that, in any given month, there is a 25 percent chance of a poor sales period and a 75 percent chance of a good sales period. What is James' expected utility from taking this job?

Accepted Answer

A)  100 
B)  150 
C)  175 
D)  200

Question 19

-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 Beatrice's expected wealth?

Accepted Answer

A)  $10,000 
B)  $50,000 
C)  $90,000 
D)  $100,000

Question 20

Assuming that the marginal utility of wealth diminishes implies that

Accepted Answer

A)  you have more total utility with $100 than with $1,000. 
B)  you have more total utility with $1,000 than with $1,001. 
C)  an additional dollar increases your total utility more if you only have $100 than if you have $1,000. 
D)  an additional dollar does not increase your total utility regardless of your wealth.

Exam 20: Uncertainty and Information