STUDY GUIDE F/MICROECONOMICS
21st Edition
ISBN: 9781307066920
Author: McConnell
Publisher: MCG/CREATE
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Chapter 4.A, Problem 3ADQ
To determine
Moral hazard problems and adverse selection problems.
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Suppose it is a well-known fact that among ten-year old Ford F-150s, half the trucks are good and half of them are lemons. Suppose that it is also known to all parties that a good truck is worth $8,000 to current owners and $10,000 to potential buyers. A bad truck, on the other hand, is only worth $1,000 to current owners and $2,000 to potential buyers.
Throughout, assume that buyers are risk-neutral.
4) Suppose that after much haggling, the current owner is willing to let her truck go for $6,000. What is the most likely implication?
a) The truck is a lemon.
b) The buyer is an excellent negotiator.
c) It's a mutually beneficial transaction.
53. The Indiana University basketball team trails by twopoints with eight seconds to go and has the ball. Shouldit attempt a two-point shot or a three-point shot?Assume that the Indiana shot will end the game and thatno foul will occur on the shot. Assume that a three-pointshot has a 30% chance of success, and atwo-point shot has a 55% chance of success. Finally,assume that Indiana has a 55% chance of winning inovertime.
Suppose the market for auto insurance is made of up two types of buyers: high-risk and low-risk. Buyers’ willingness to pay (WTP) for auto insurance plans, and sellers’ willingness to accept (WTA) when selling plans to each type of buyer, are outlined in a photo
(a) In a world with perfect information, would the market for insurance plans clear? If not, why? If yes, what are some prices that would a llow both markets to clear? The prices in each market are allowed to differ
Assume now that there is asymmetric information and that insurance companies do not know how risky an individual buyer is. In the face of this uncertainty, they determine that the probability that a “walk-in” is high-risk is 0.75.
What is the minimum price sellers are willing to accept when selling an insurance plan? At this price, will low- and high-risk buyers both be willing to purchase this insurance plan? Explain. Be sure the mention adverse selection in your answer.
Chapter 4 Solutions
STUDY GUIDE F/MICROECONOMICS
Ch. 4.A - Prob. 1ADQCh. 4.A - Prob. 2ADQCh. 4.A - Prob. 3ADQCh. 4.A - Prob. 1ARQCh. 4.A - Prob. 2ARQCh. 4.A - Prob. 3ARQCh. 4.A - Prob. 1APCh. 4 - Prob. 1DQCh. 4 - Prob. 2DQCh. 4 - Prob. 3DQ
Ch. 4 - Prob. 4DQCh. 4 - Prob. 5DQCh. 4 - Prob. 6DQCh. 4 - Prob. 7DQCh. 4 - Prob. 8DQCh. 4 - Prob. 9DQCh. 4 - Prob. 1RQCh. 4 - Prob. 2RQCh. 4 - Prob. 3RQCh. 4 - Prob. 4RQCh. 4 - Prob. 5RQCh. 4 - Prob. 6RQCh. 4 - Prob. 7RQCh. 4 - Prob. 1PCh. 4 - Prob. 2PCh. 4 - Prob. 3PCh. 4 - Prob. 4PCh. 4 - Prob. 5PCh. 4 - Prob. 6PCh. 4 - Prob. 7P
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- How can moral hazard lead to more costly insurance premiums than one was expected?arrow_forwardNow suppose agent C can produce private information about the true realization x at t=1 at the cost γ=4. Suppose lA=lB=φA=φB=1 and x is either 40 or 100 with equal probability and w=70. - At t=1, agent B owns the bond. What is the maximum amount LB that agent B can borrow with probability 1?- At t=0, what amount LA can agent A borrow from agent B in a repo trade at t=0 and what is the haircut in equilibrium?arrow_forward6. Which is the best example of health care insurance in the sense of socializing risk?a. A dental insurance policy that pays for two check-ups a year but nothing else.b. A comprehensive health care policy that essentially pays for everything including check ups but is very expensivec. A health care policy that is relatively inexpensive but only pays for medical expenses after a $2,000 annual deductible is met. After $2,000 the policy pays 100 percent for everything.arrow_forward
- 1)Describe an example of moral hazard that we may run into in the real world. Think of something that is legal and not inherently lethal, yet still demonstrates elevated risk for the participant who would likely act safer if insurance or protection was not available. Explain why someone might take this risky action. What are the benefits to the risky behavior? In your response to two of your peers, explain what an insurance company may do to reduce the likelihood that an individual would take this risk. Keep in mind, that we cannot always just deny coverage if an individual is participating in the risky behavior.arrow_forwardSay there are two individuals; Hala and Anna who are deciding on either to buy health insurance on a pooling arrangement basis or otherwise. Both face a 30% probability of losing RM40 on medical services and 70% of losing nothing. With these information discuss whether Hala and Anna should join this arrangement or pay the medical services costs out of their own pocket money.arrow_forwardIn an insurance system, would you expect each person to receive in benefits pretty much what they pay in premiums or is it just that the average benefits paid will equal the average premiums paid?arrow_forward
- 1. Imagine that you are faced with the following three public projects, each of which costs $3000. Please assume that this cost is applied to the project at Year 0 for all three cases. Which option would you decide to build? Please assume that the discount rate is 12 percent, and that benefits start in Year 1. Make sure that you explain why you would choose the option that you select. a. A parking structure that yields $1050 of benefits per year for 10 years b. A landfill that yields $800 of benefits per year for 6 years c. A new wastewater treatment plant that would yield $600 benefit per year forever 2. Would your answer to Problem 2 change if the discount rate were 5 percent? In this case, which of the three options would you choose and why? Construct your solutions to these questions in an Excel file with seven tabs. One tab for your verbal answers to questions 1 and 2 above, and six tabs for the calculations (a separate tab for each of the three problems…arrow_forward18.5 Suppose there is a 50–50 chance that an individual with log- arithmic utility from wealth and with a current wealth of $20,000 will suffer a loss of $10,000 from a car accident. Insur- ance is competitively provided at actuarially fair rates. Compute the outcome if the individual buys full insurance. Compute the outcome if the individual buys only partial insurance covering half the loss. Show that the outcome in part (a) is preferred. Now suppose that individuals who buy the partial rather than the full insurance policy take more care when driv- ing, reducing the damage from loss from $10,000 to $7,000. What would be the actuarially fair price of the partial policy? Does the individual now prefer the full or the partial policy?arrow_forward3. Briefly explain how asymmetric information in the used car market can result in adverse selection and what can be done to mitigate the problem.arrow_forward
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