dverse Selection and Moral Hazard.

(3 points). When Sofia buys a computer for $1,000, she knows that there is a 10% chance that it will break within the first year if she treats it with care. She is risk averse and would therefore pay up to $120 for a warranty that will replace the computer if it breaks for any reason during this period.

1. If a risk-neutral firm offered her a warranty at this price, what would its expected profits be if it sold her a warranty at this price?Assume that she treats the computer with care.

Expected Profits = (Chance of Computer Not Breaking Premium Received) +

(Chance of Com Expected Profits = (Chance of Computer Not Breaking Premium Received) +

(Chance of Computer Breaking Replacement Cost Premium)

Expected Profits = (90% $120) + [10% ($120 - $1,000)]

Expected Profits = $20

1. (3 points). Explain how moral hazard might undermine the firm's calculations.

Moral hazardmeans Sofia knows that she will be fully covered if anything happens to the computer within the first year. Hence, she might not be as careful since she has already paid the warranty money, and there will be an increase in the chance that the computer will break. This will reduce the expected profits of the firm. For example, even a 2.5% increase (12.5% chance of computer breaking) will yield negative profits.

(3 points). Alejandro is less careful than Sofia.

There is a 20% change the $1,000 computer will break within the first year if he treats it with care. He is also risk-averse and would pay up to $220 for a similar warranty. If a risk-neutral firm sold him a warranty for $220, what would its expected profits be?

1. Assume that he treats the computer with care.

Expected profits of firm (using same formula) = 80%*220 + 20%*(220-1000) =$20 assuming he treats with care.

(3 points). Suppose that the firm cannot work out who is careful and who is not. Who will buy the warranty for $120 (Sofia's reservation price)?

1. What would the firm's profits be if it offered to sell its warranty to anyone who wants it at this price?Assume that the customers will treat the computer with care.

1. (3 points). Suppose that the firm cannot work out how it is careful and who is not. Who will buy the warranty at a price of $170 (the average of Alejandro and Sofia's reservation prices)? What would the firm's profits be if it offered to sell its warranty to anyone who wants it at this price?Assume that the customers will treat the computer with care.

1. (3 points). Suppose that the firm cannot work out how it is careful and who is not. Who will buy the warranty at a price of $220 (Alejandro's reservation price)? What would the firm's profits be if it offered to sell its warranty to anyone who wants it at this price?Assume that the customers will treat the computer with care.