Suppose a lottery has an expected value equal to $50 of winnings. Someone who values this

lottery at

less

than its expected value is...

a.

risk-seeking

b.

risk-neutral

c.

risk-averse

d.

Cannot be determined

Use the following information for questions 2-6

Both Nadia and Samantha are applying to insure their respective cars (valued at $10,000 each)

against the possibility of being stolen.

Nadia lives in a secure neighborhood, where the probability of theft is 10%. Samantha lives in a

less secure neighborhood where the probability of theft is 25%. They are both risk-averse, and

so each is willing to pay "$100 over expected loss" for insurance.

2. How much would Nadia be willing to pay for the insurance?

a.

$900

b.

$1000

c.

$1100

d.

$1200

3. Suppose the insurance company cannot tell Nadia and Samantha apart in terms of how

"risky" their neighborhoods are. However, because the company suspects that the risk levels

may be different, it decides that it would be willing to sell policies to each of them for $1850.

Who is likely to actually buy this insurance?

a.

Samantha

b.

Nadia

c.

Both of them

d.

Neither of them

4. If we assume that: (a) the insurance company charges a premium of $1850, and (b) both

Nadia and Samantha decide

correctly

whether or not to purchase based on their respective

values for the insurance, how much profit on average would the insurer expect to make?

a.

$1850

b.

Zero, the insurer would break even

c.

The insurer would incur a loss of $650

d.

The insurer would incur a loss of $1100

5. If the company

correctly

anticipates

the adverse selection problem in this situation, what

premium would it charge?

a.

$2500

b.

$2600

c.

$1000

d.

$1100

6. Suppose that not only does the company correctly anticipate the adverse selection problem,

it does even better by successfully "screening" both Nadia and Samantha into appropriate

insurance policies. If this is true, then

on the average

we would expect the company to earn...

a.

a loss equal to ($200)

b.

a profit equal to $200

c.

a loss equal to ($3500)

d.

a profit equal to $3500

7. To signal to your insurance company that you are a low risk individual, and thereby secure a

lower premium, you should...

a.

accept an insurance policy with a high deductible

b.

accept an insurance policy with a low deductible

c.

accept an insurance policy with a co-payment

d.

Both A&C

8. [

BONUS

] "Dangerous" Dan says that he got his nickname because he is a "risk-seeking" type

of dude who likes to live dangerously! Dan has the opportunity to play (only) one of two

carnival games.

Carnival game A costs $60 to play. If Dan wins (Probability = 1/3), he gets a nice, big

teddy bear worth $120; if he loses (Pr = 2/3) then he doesn't get the bear.

Carnival game B costs $50 to play. If Dan wins (Pr = 1/5), he gets an even

bigger

teddy

bear worth $250! However, if he loses (Pr = 4/5), then he doesn't get the bear.

After thinking about his choice for a couple minutes, Dan decides to play game B. Given that he

chose game B, we can safely assume that...

a.

Dan is telling the truth about his personality-type. He has definitely earned the right to

be known as "Dangerous" Dan.

b.

Dan is a liar and a wimp and is probably just some nerd that made up his own nickname.

c.

Dan is a liar, but we don't really know if he's a wimp or not because his decision indicates

that he is risk-neutral. (Either way, it's still dumb to give yourself your own nickname.)

d.

Dan is 40 years old. What is he going to do with a teddy bear?

Use the following information for question 9

Terri wants to avoid any accidents on the work floor of her factory. If an accident does occur, it

would cost her $500,000 in damages. Installing safety equipment would decrease the

probability of an accident occurring from 20% to 10%. However, the equipment costs $20,000

to install.

9. Would Terri install the safety equipment?

a.

Yes, because it costs her less than it is worth

b.

Yes, because it costs her more than it is worth

c.

No, because it costs her more than it is worth

d.

No, because it costs her less than it is worth

10. An example of moral hazard is...

a.

a taxi driver paid per mile taking a longer route than necessary

b.

a piece-rate garment worker shirking more than a per hour worker

c.

an hourly salesman working harder than a commission salesman

d.

an author on contract going to as many book signings as one with a percentage royalty

rate

11. Adverse selection might happen during the hiring process because...

a.

applicants ultimately have more information about themselves than do job interviewers

b.

applicants might try to disguise their "type" by trying to appear more self-motivated than

they really are

c.

applicants who are most likely to accept a salary offer are often the least qualified

d.

All of the above

12. A shoe salesman working on commission must decide whether to work hard or shirk.

Working hard would increase the probability of a sale from 20% to 70%, but the effort would

cost him $5. If the typical commission on a pair of shoes was $8, would he decide to work hard?

a.

Yes, because it is higher than what it costs him in effort

b.

Yes, because it is higher than zero

c.

No, because it costs him more in effort

d.

None of the above

13. Sam is negotiating a $200 loan from the bank in order to finance an investment. He tells the

bank that there is a 50% chance that the investment will pay out $1000 and a 50% chance that it

will pay out $0. After consideration, the bank agrees to grant him the loan at 100% interest.

However, after receiving the $200 from the bank, Sam discovers a different, potentially riskier

investment that pays out $4,000 10% of the time, while the other 90% of the time it pays $0.

Would Sam want to secretly switch to the riskier investment?

a.

Yes, because his expected return would increase

b.

No, because his liability to the bank would increase

c.

No, because his expected return would decrease

d.

None of the above

14. Which of the following is true?

a.

Investors are often inclined to take bigger risks with their own money than they would

with other peoples' money

b.

Investors are often inclined take bigger risks with other peoples' money than they would

with their own money

c.

It does not matter whether or not investors are investing with other peoples' money.

The only thing that matters is if the lenders are risk-neutral or not