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Chapter 15 Adverse Selection
MULTIPLE CHOICE
1. Adverse selection implies that:
a.
the market for used cars is perfectly competitive
b.
the market for used cars will contain more cars of higher than average quality
c.
the market for used cars will contain more cars of lower than average quality
d.
all used cars will be of equal quality
e.
the government overinsures the market for used cars
2. From whom would you prefer to buy a used car, everything else being equal?
a.
a mechanic
b.
a used car dealer
c.
a family that is moving to China
d.
a person who is buying a new car
e.
You would have no preference among these choices.
3. Suppose that in Milford, Connecticut, owners of used cars that are lemons value their cars at
$2,500, and owners of used cars that are reliable value their cars at $6,000. There are equal
quantities of each type of car on the market. Buyers value low-quality cars at $1,500 and
high-quality cars at $7,000. In this market:
a.
only low-quality cars will be sold at a price of $1,500
b.
only low-quality cars will be sold at a price of $2,500
c.
all cars will sell at a price of $4,250
d.
only high-quality cars will be sold at a price of $6,000
e.
only high-quality cars will be sold at a price of $7,000
Please use the following information for the following questions.
Suppose the Ajax Insurance Company provides insurance for skydivers whose wealth
before diving is $400. An accident will leave divers with a wealth of $100. The company
divides the divers into two classes, safe (probability of an accident = 0.2) and unsafe
(probability of an accident = 0.5). The utility of wealth for all divers is given by the
function: U(w) = w0.5.
4. Given this information, the divers are:
a.
risk-averse
b.
risk seeking
c.
risk-neutral
d.
indifferent to risk
e.
risk-averse, risk seeking, or risk-neutral; we cannot tell from this information
5. The utility of no insurance for the safe diver is:
a.
15
b.
17.3
c.
18
d.
18.3
e.
none of the above
6. If the insurance premium is $100:
a.
both types of divers buy insurance
b.
neither type of diver buys insurance
c.
only the safe divers buy insurance
d.
only the unsafe divers buy insurance
7. If the insurance premium is $50:
a.
both types of divers buy insurance
b.
neither type of diver buys insurance
c.
only the safe divers buy insurance
d.
only the unsafe divers buy insurance
8. If only the unsafe divers buy insurance and the premium is $100, the insurance company
will:
a.
earn a profit of $100 per unsafe diver
b.
break even
c.
incur a loss of $200 per unsafe diver
d.
incur a loss of $300 per unsafe diver
e.
experience none of the above
9. Most states require car owners to provide evidence that they have auto insurance when they
register their cars and obtain license plates. For the sellers of insurance policies, this may
help to limit the severity of the:
a.
information asymmetry
b.
moral hazard problem
c.
signaling problem
d.
adverse selection problem
e.
Akerlof problem
10. Which of the following is the best example of adverse selection?
a.
Smokers are more likely to obtain health insurance.
b.
Safe drivers tend to get auto insurance.
c.
All drivers are required to have auto insurance if they are to register their cars
legally in Connecticut.
d.
Both healthy and unhealthy people tend to buy life insurance.
e.
Given the existence of government-funded flood insurance, people continue to
build homes in flood plains.
11. Insurance companies are able to offset the adverse selection in markets for life insurance by:
a.
requiring premiums that are above the expected value of receipts
b.
only insuring people who appear to be sick
c.
insuring a wide variety of people so that gains on some policies offset losses on
others
d.
requiring medical exams from people whom they insure
e.
requiring higher premiums from healthy people than from sick people
12. One way to solve the problem of adverse selection in markets for homeowner’s insurance is
to:
a.
only insure customers who make claims against their policies
b.
use deductibles to encourage safe behavior
c.
offer premium discounts to people who install house alarm systems
d.
require homeowner’s insurance as a condition of acquiring a mortgage
e.
b, c, and d
Please use the following diagram to answer the following questions.
13. In this case, the best possible pricing scheme would:
a.
encourage high-risk individuals to obtain full coverage
b.
encourage all individuals to obtain full coverage
c.
establish a single premium for all individuals
d.
encourage only low-risk individuals to buy any insurance
e.
result in no coverage purchased by low- or high-risk individuals
14. In this case, the high-risk individuals choose:
a.
the full coverage policy
b.
the partial coverage policy
c.
no coverage
d.
none of the above
15. In this case, the low-risk individuals choose:
a.
the full coverage policy
b.
the partial coverage policy
c.
no coverage
d.
none of the above
16. The signaling model of education would be ineffective if:
a.
skills learned in school were useful in employment and could be effectively tested
b.
the costs of acquiring education were equal for individuals of different abilities
c.
individuals could not identify their own abilities
d.
b and c
e.
all of the above
17. Requiring applicants for life insurance to undergo a physical examination is an effective
way to:
a.
reduce moral hazard
b.
increase information asymmetry
c.
reduce adverse selection
d.
increase sales
e.
none of the above
18. Which of the following is a credible signal of product quality?
a.
a money back guarantee
b.
high price
c.
a warrantee
d.
assurances by a salesperson
e.
a and c
Use the information that follows to answer the following questions. Good drivers have a 20
percent chance, and bad drivers have a 50 percent chance, of getting in an accident. A car is
worth $900, and an accident would reduce its value to $400. Both types of drivers have
utility U = (car value)0.5?
19. What is a good driver’s expected utility without insurance?
a.
20
b.
25
c.
28
d.
30
e.
none of the above
20. What is a bad driver’s expected utility without insurance?
a.
20
b.
25
c.
28
d.
30
e.
none of the above
21. If an insurance policy costs $200 and will pay $400 in case of an accident, what decision
will be made by the two drivers?
a.
Both drivers will buy insurance.
b.
Neither driver will buy insurance.
c.
The good driver will buy insurance and the bad driver won’t.
d.
The bad driver will buy insurance and the good driver won’t.
22. If an insurance policy costs $80 and will pay $400 in case of an accident, what decision will
be made by the two drivers?
a.
Both drivers will buy insurance.
b.
Neither driver will buy insurance.
c.
The good driver will buy insurance and the bad driver won’t.
d.
The bad driver will buy insurance and the good driver won’t.
