Page 1
1.
Louis has invested $1,000 in the stock market. At the end of one year, there is a 30%
chance that his stock will be worth only $800 and a 70% chance that it will be worth
$1,200. The expected value of his stock at the end of one year is:
A)
$1,000.
B)
$1,080.
C)
$1,200.
D)
$1,160.
2.
Domingo has a total wealth of $500,000 composed of a house worth $100,000 and
$400,000 in cash. He keeps the cash in a safe deposit box, so that it is completely safe.
However, there is a 10% chance that his house will burn down by the end of the year
and be worth nothing and a 90% chance that nothing will happen to it. Without
insurance, the expected value of his end-of-year wealth is:
A)
$410,000.
B)
$450,000.
C)
$490,000.
D)
$485,000.
3.
Micah is considering turning pro before his senior year basketball season. If he turns
pro, Micah expects a pro contract worth $2 million in present value. If he does not turn
pro, there is a 50% chance an injury will prevent him from playing professionally and a
50% chance he will get a pro contract worth $4 million in present value. What is the
expected present value of Micah’s pro contract if he stays in college for his senior year?
A)
$3.5 million
B)
$5 million
C)
$2 million
D)
$0
4.
Amanda recently graduated from college, and she has a job offer with uncertain income:
there is a 70% probability that she will make $10,000 and a 30% probability that she
will make $70,000. The expected value of Amanda’s income is:
A)
$40,000.
B)
$21,000.
C)
$28,000.
D)
$10,000.
5.
A random variable:
A)
has an uncertain future value.
B)
has a constant value.
C)
doesn’t exist in economics.
D)
is useless in economic decision making.
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6.
The expected value of a random variable is:
A)
the most frequently occurring value of that variable.
B)
the most recent value of that variable.
C)
the weighted average of all possible values, where the weights on each possible
value correspond to the probability of that value occurring.
D)
impossible to determine.
7.
If there is a 25% probability that Joseph will earn $10 per hour at his job today and a
75% probability that he will earn $20 per hour today, his expected pay per hour is:
A)
$10.00.
B)
$15.00.
C)
$17.50.
D)
$20.00.
8.
If there is a 50% probability that Joseph will earn $10 per hour at his job today and a
50% probability that he will earn $20 per hour today, his expected pay per hour is:
A)
$10.00.
B)
$12.50.
C)
$15.00.
D)
$20.00.
9.
If a stock analyst believes there is a 25% probability that the stock price of Dymonatis
will be $30 at the end of the year, a 50% probability that it will be $40, and a 25%
probability that it will be $50, then the expected value of the stock at the end of the year
is:
A)
$30.
B)
$35.
C)
$40.
D)
$50.
10.
If a stock analyst believes there is a 10% probability that the stock price of Dymonatis
will be $30 at the end of the year, a 50% probability that it will be $40, and a 40%
probability that it will be $50, then the expected value of the stock at the end of the year
is:
A)
$32.
B)
$38.
C)
$40.
D)
$43.
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11.
Uncertainty about monetary outcomes is known as:
A)
financial risk.
B)
monetary risk.
C)
profitability risk.
D)
risk aversion.
12.
A friend of yours owes you $10, and he wants to flip a coin for double or nothing. If the
coin lands heads, he will pay you $20. If the coin lands tails up, he will pay you nothing.
As the coin is in midair, what is your expected value of this wager?
A)
$0
B)
$10
C)
$20
D)
$30
13.
You are about to have a meeting with your manager about a raise in your salary. You
are going to request an increase of $5,000, but you believe the probability of success to
be only 25%. You believe there is a 25% probability your boss will counter with a
$3,000 raise and a 25% probability that your boss will offer a $1,000 raise. Finally,
there is a 25% probability that you will receive no increase in your salary. What is the
expected value of the outcome of your meeting?
A)
$2,250
B)
$9,000
C)
$6,750
D)
$3,000
14.
Darnell pays $7,300 per year to an insurance company in return for its promise to pay
part of his family’s medical bills. The $7,300 is Darnell’s:
A)
risk.
B)
marginal utility.
C)
expected utility.
D)
premium.
15.
A fair insurance policy is one whose premium is _____ the expected value of the claims.
A)
equal to
B)
greater than
C)
less than
D)
unrelated to
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16.
Suppose that an individual is risk-averse. If this individual’s utility function is depicted
in a graph, with income measured on the horizontal axis and utils on the vertical axis,
the graph will be an upward-sloping:
A)
straight line through the origin.
B)
straight line with a positive vertical intercept.
C)
curve with a steadily increasing slope (i.e., a curve that is convex from below).
D)
curve with a steadily decreasing slope (i.e., a curve that is concave from below).
17.
Amanda recently graduated from college, and she has a job offer with uncertain income.
There is a 70% probability that she will make $10,000 and a 30% probability that she
will make $70,000. Suppose Amanda is offered another job with a certain income. All
else equal, if she has a constant marginal utility of income, she will accept the second
job offer only if it pays more than:
A)
$40,000.
B)
$28,000.
C)
$10,000.
D)
$21,000.
18.
Domingo has total wealth of $500,000 composed of a house worth $100,000 and
$400,000 in cash. He keeps the cash in a safe deposit box, so that it is completely safe.
However, there is a 10% chance that his house will burn down and be worth nothing and
a 90% chance that nothing will happen to it. Domingo buys insurance guaranteeing that
his house will be restored to its original condition should anything happen to it. The
insurance premium is $2,000. Consequently (assuming other things remain unchanged),
his future:
A)
expected wealth is $480,000.
B)
wealth is $500,000 for sure.
C)
expected wealth is $490,000.
D)
wealth is $498,000 for sure.
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19.
The Conduire family owns three cars and is considering buying insurance to cover the
cost of repairs. They face two possible states: state 1, in which their cars need no repairs
and their income available for purchasing other goods and services is equal to $50,000;
and state 2, in which their cars need $10,000 worth of repairs and their income available
for purchasing other goods and services is reduced to $40,000. The probability of
occurrence is 0.5 for each state. They can buy insurance that will cover the full cost of
repairs for $5,000. If the Conduires are risk-averse and maximize their expected utility:
A)
they will buy the insurance.
B)
they will be indifferent between buying and not buying the insurance, since their
expected income for purchasing other goods and services is $45,000 regardless of
what they do.
C)
they will not buy the insurance, since buying it does not increase their expected
income for purchasing other goods and services.
D)
they will put $10,000 in savings to pay for any required repairs and not buy
insurance.
20.
The total utility of income curve for a risk-averse individual will be _____ with income.
A)
decreasing
B)
increasing at an increasing rate
C)
increasing at a constant rate
D)
increasing at a decreasing rate
21.
Individuals differ in risk aversion because of:
A)
adverse selection.
B)
moral hazard.
C)
differences in income or wealth.
D)
differences in their insurance.
22.
If an individual is risk-averse, then his or her total utility function must display _____
marginal utility.
A)
constant
B)
diminishing
C)
increasing
D)
either constant or diminishing, but not increasing,
23.
The marginal utility of income for a risk-averse individual will be:
A)
constant.
B)
diminishing.
C)
increasing.
D)
unknown; the answer depends on the value of income.
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24.
For most families, total utility does NOT:
A)
rise as income rises.
B)
rise less quickly as income rises.
C)
show increasing marginal utility.
D)
show diminishing marginal utility.
25.
For most families, the marginal utility of income is:
A)
increasing.
B)
constant.
C)
diminishing.
D)
unknown; the answer depends on the value of income.
26.
A fair insurance policy is one whose premium:
A)
is zero.
B)
allows the insurance company to profit.
C)
equals the expected value of the claims.
D)
is higher as the probability of a claim decreases.
Use the following to answer questions 27-28:
Figure: Differences in Risk Aversion
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27.
(Figure: Differences in Risk Aversion) Look at the figure Differences in Risk Aversion.
Which of the following statements is CORRECT?
A)
Ernest will gain more utility from insurance than will Salvatore.
B)
Salvatore will gain less utility from an increase in income than Ernest but will lose
more utility than Ernest from a fall in income.
C)
Ernest is more risk-averse than Salvatore.
D)
If either Ernest or Salvatore buys insurance, adverse selection will occur.
28.
(Figure: Differences in Risk Aversion) Look at the figure Differences in Risk Aversion.
An important reason Ernest and Salvatore may differ in their aversion to risk is:
A)
the way their marginal utility is affected by income.
B)
their understanding of risk.
C)
their initial wealth holding or initial income level.
D)
the way their marginal utility is affected by income and their initial wealth holding
or initial income level.
29.
A person who is willing to pay an insurance premium to lessen financial risk is said to
be:
A)
a moral hazard.
B)
risk-loving.
C)
risk-averse.
D)
risk-neutral.
30.
Bikul has just started a great job and plans to buy a fancy car worth $100,000. Bikul is
risk-averse in money matters, but he likes to drive fast, so the probability that he wrecks
the car (a total loss of $100,000) is 0.10. The probability that he has no accidents is 0.90.
If an insurance company offers Bikul a fair insurance policy, the premium will be:
A)
$10,000.
B)
$90,000.
C)
$80,000.
D)
It is impossible to calculate a premium unless we know Bikul’s utility function.
31.
The premium for a(n) _____ insurance policy is equal to the expected value of the
claim.
A)
fair
B)
premium
C)
unfair
D)
diversification
Page 8
Use the following to answer questions 32-33:
Figure: Risk Aversion
32.
(Figure: Risk Aversion) Look at the figure Risk Aversion. Bob and Nancy have the
same income and the same total utility. Nancy is _____ risk-averse than Bob because
her marginal utility curve is _____ than Bob’s.
A)
more; flatter
B)
more; steeper
C)
less; flatter
D)
less; steeper
33.
(Figure: Risk Aversion) Look at the figure Risk Aversion. Bob and Nancy have the
same income and total utility. Nancy will be willing to pay a ____ insurance premium
than Bob because she is _____ risk-averse.
A)
higher; more
B)
lower; more
C)
lower; less
D)
higher; less
Page 9
Use the following to answer questions 34-35:
34.
(Table: Utility for Terri and Mary) Look at the table Utility for Terri and Mary. Each
has an income of $300. _____ is more risk-averse because _____ has a _____ drop in
total utility if income were to fall by $100.
A)
Mary; Mary; larger
B)
Terri; Mary; larger
C)
Mary; Terri; smaller
D)
Terri; Terri; larger
35.
(Table: Utility for Terri and Mary) Look at the table Utility for Terri and Mary. Each
has an income of $300. If each were offered insurance to offset the risk of falling
income, _____ would pay a larger premium because she is the consumer with _____
risk aversion.
A)
Terri; more
B)
Terri; less
C)
Mary; more
D)
Mary; less
36.
Risk-averse individuals are willing to pay a premium that is _____ their expected
claims.
A)
less than
B)
greater than or equal to
C)
equal to
D)
dependent on something other than
Page 10
37.
When faced with an insurance policy whose premium exceeds the expected value of the
claim:
A)
no one will buy it.
B)
only risk-tolerant individuals will buy it.
C)
risk-averse individuals will buy it as long as the utility associated with the
insurance is greater than the expected utility without the insurance.
D)
risk-averse individuals will buy it as long as the utility associated with the
insurance is less than the expected utility without the insurance.
38.
Which of the following regarding a warranty is NOT true?
A)
It is a form of consumer insurance.
B)
Consumers may buy one even if the cost of the warranty is greater than the
expected future claim paid by the manufacturer.
C)
It decreases the consumer’s expected utility from an item.
D)
It signals to consumers that the goods are of high quality.
Use the following to answer questions 39-41:
39.
(Table: Income and Utility for Whitney) Look at the table Income and Utility for
Whitney. Whitney’s income next year is uncertain: there is a 40% probability she will
make $40,000 and a 60% probability she will make $80,000. What certain income
leaves Whitney as well off as her uncertain income?
A)
$64,000
B)
$60,000
C)
$54,000
D)
$50,000
Page 11
40.
(Table: Income and Utility for Whitney) Look at the table Income and Utility for
Whitney. Whitney’s income next year is uncertain: there is a 40% probability she will
make $40,000 and a 60% probability she will make $80,000. Whitney’s expected utility
is _____ utils.
A)
135
B)
124
C)
120
D)
130
41.
(Table: Income and Utility for Whitney) Look at the table Income and Utility for
Whitney. Whitney’s income next year is uncertain: there is a 40% probability she will
make $40,000 and a 60% probability she will make $80,000. The expected value of
Whitney’s income is:
A)
$64,000.
B)
$80,000.
C)
$40,000.
D)
$56,000.
Use the following to answer questions 42-43:
42.
(Table: Income and Utility for Rahim) Look at the table Income and Utility for Rahim.
The expected value of Rahim’s income is:
A)
$221,000.
B)
$20,000.
C)
$110,000.
D)
$70,200.
43.
(Table: Income and Utility for Rahim) Look at the table Income and Utility for Rahim.
Rahim’s expected utility from income is:
A)
3,500 utils.
B)
10,000 utils.
C)
3,104 utils.
D)
Utility cannot be determined from the information given.
Page 12
Use the following to answer questions 44-48:
44.
(Table: Income and Utility for Tyler) The table Income and Utility for Tyler shows the
utility Tyler receives at various income levels, but she does not know what her income
will be next year. There is a 40% chance her income will be $20,000, a 40% chance her
income will be $30,000, and a 20% chance her income will be $40,000. We know that
Tyler is risk-averse because:
A)
Tyler would prefer $40,000 but there is a risk she will make only $20,000.
B)
Tyler’s expected income is less than what she may actually earn.
C)
Tyler’s expected income is more than what she may actually earn.
D)
Tyler is subject to diminishing marginal utility from income.
45.
(Table: Income and Utility for Tyler) The table Income and Utility for Tyler shows the
utility Tyler receives at various income levels, but she does not know what her income
will be next year. There is a 40% chance her income will be $20,000, a 40% chance her
income will be $30,000, and a 20% chance her income will be $40,000. What is her
expected income?
A)
$28,000
B)
$29,000
C)
$30,000
D)
$31,000
Page 13
46.
(Table: Income and Utility for Tyler) The table Income and Utility for Tyler shows the
utility Tyler receives at various income levels, but she does not know what her income
will be next year. There is a 40% chance her income will be $20,000, a 40% chance her
income will be $30,000, and a 20% chance her income will be $40,000. What is her
expected utility in utils?
A)
3,270
B)
3,144
C)
3,420
D)
3,480
47.
(Table: Income and Utility for Tyler) The table Income and Utility for Tyler shows the
utility Tyler receives at various income levels, but she does not know what her income
will be next year. There is a 40% chance her income will be $20,000, a 40% chance her
income will be $30,000, and a 20% chance her income will be $40,000. What level of
certain income matches her expected utility, given the uncertainty?
A)
$28,000
B)
$25,000
C)
$26,516
D)
$29,000
48.
(Table: Income and Utility for Tyler) The table Income and Utility for Tyler shows the
utility Tyler receives at various income levels, but she does not know what her income
will be next year. There is a 40% chance her income will be $20,000, a 40% chance her
income will be $30,000, and a 20% chance her income will be $40,000. What is the
maximum amount of insurance Tyler would be willing to pay to guarantee an income of
$28,000?
A)
$0
B)
$1,484
C)
$26,516
D)
$126
Page 14
Use the following to answer questions 49-54:
49.
(Table: Natasha’s Total Utility) Look at the table Natasha’s Total Utility. Natasha’s
marginal utility _____ as her income increases. The marginal utility of income between
$30,000 and $32,500 is _____ utils per dollar, while it is _____ utils per dollar between
$47,500 and $50,000.
A)
increases; 0.48; 0.64
B)
increases; 0.12; 0.36
C)
diminishes; 0.50; 0.25
D)
diminishes; 0.32; 0.04
50.
(Table: Natasha’s Total Utility) Look at the table Natasha’s Total Utility. Natasha earns
$50,000 per year but faces losing $20,000 of it if she is late with her work. If there is a
25% probability that Natasha will be late with her work and her income will then equal
$30,000, her expected income is:
A)
$32,500.
B)
$38,200.
C)
$40,500.
D)
$45,000.
Page 15
51.
(Table: Natasha’s Total Utility) Natasha earns $50,000 per year but faces losing $20,000
of it if she is late with her work. If there is a 25% probability that Natasha will be late
with her work and her income will then equal $30,000, her expected total utility is
_____ utils.
A)
4,175
B)
3,700
C)
3,620
D)
3,259
52.
(Table: Natasha’s Total Utility) Look at the table Natasha’s Total Utility. Natasha earns
$50,000 per year but faces losing $20,000 of it if she is late with her work. If there is a
25% probability that Natasha will be late with her work and her income will equal
$30,000, what certain income leaves Natasha just as well off as her uncertain income?
A)
$37,500
B)
$38,200
C)
$40,500
D)
$42,500
53.
(Table: Natasha’s Total Utility) Look at the table Natasha’s Total Utility. Natasha earns
$50,000 per year but faces losing $20,000 of it if she is late with her work. If there is a
25% probability that Natasha will be late with her work and her income will equal
$30,000, To guarantee an income of $50,000, Natasha would be willing to pay _____
for insurance.
A)
$4,000
B)
$5,000
C)
$7,500
D)
$9,500
54.
(Table: Natasha’s Total Utility) Look at the table Natasha’s Total Utility. Natasha earns
$50,000 per year but faces losing $20,000 of it if she is late with her work. If there is a
25% probability that Natasha will be late with her work and her income will equal
$30,000, the premium for a fair insurance policy to eliminate the uncertainty in her
income would equal:
A)
$4,000.
B)
$5,000.
C)
$7,500.
D)
$9,500.
Page 16
Use the following to answer questions 55-61:
55.
(Table: Total Utility of Income After College Expenses) Look at the table Total Utility
of Income After College Expenses. The Smith family has _____ marginal utility as
income increases. The marginal utility of income between $32,500 and $35,000 is
_____ utils per dollar, while it is _____ utils per dollar between $45,000 and $47,500.
A)
increasing; 0.48; 0.64
B)
increasing; 0.12; 0.36
C)
diminishing; 0.28; 0.08
D)
diminishing; 0.40; 0.10
56.
(Table: Total Utility of Income After College Expenses) Look at the table Total Utility
of Income After College Expenses. The Smith family’s expected income after tuition is:
A)
$32,500.
B)
$38,000.
C)
$40,000.
D)
$45,000.
Page 17
57.
(Table: Total Utility of Income After College Expenses) Look at the table Total Utility
of Income After College Expenses. The Smith family’s expected total utility is _____
utils.
A)
4,175
B)
3,700
C)
3,620
D)
3,210
58.
(Table: Total Utility of Income After College Expenses) Look at the table Total Utility
of Income After College Expenses. What certain income after tuition leaves Mr. and
Mrs. Smith just as well off as their uncertain income after tuition?
A)
$37,500
B)
$38,000
C)
$40,500
D)
$42,500
59.
(Table: Total Utility of Income After College Expenses) Look at the table Total Utility
of Income After College Expenses. Mr. and Mrs. Smith would be willing to pay as
much as _____ for insurance to pay their daughter’s tuition and eliminate the uncertainty
in the family’s income after tuition.
A)
$12,000
B)
$10,000
C)
$8,000
D)
$5,000
60.
(Table: Total Utility of Income After College Expenses) Look at the table Total Utility
of Income After College Expenses. The premium for a fair insurance policy to pay their
daughter’s tuition and eliminate the uncertainty in the Smith family’s income after
tuition would equal:
A)
$12,000.
B)
$10,000.
C)
$8,000.
D)
$5,000.
Page 18
61.
(Table: Total Utility of Income After College Expenses) The Smith family will choose
to purchase insurance:
A)
at any premium.
B)
at a premium for which the reduction in risk leaves the expected value of their
income after tuition the same.
C)
up to but not exceeding the point at which the premium is that of a fair insurance
policy.
D)
at a premium for which the reduction in risk is that of a fair insurance policy.
Use the following to answer questions 62-70:
62.
(Table: Choice with Uncertainty) Look at the table Choice with Uncertainty. Suppose
the probability that the sitcom does not make it to television is 50%, that it makes it to
television but is not the most viewed show in its time slot is 30%, and that it makes it to
television and is the most viewed show in its time slot is 20%. Given this information,
Norman’s expected income is:
A)
$52,500.
B)
$47,500.
C)
$40,000.
D)
$37,500.
Page 19
63.
(Table: Choice with Uncertainty) Look at the table Choice with Uncertainty. Suppose
the probability that the sitcom does not make it to television is 50%, that it makes it to
television but is not the most viewed show in its time slot is 30%, and that it makes it to
television and is the most viewed show in its time slot is 20%. Given this information,
Norman’s expected total utility is _____ utils.
A)
2,000
B)
2,150
C)
2,350
D)
2,650
64.
(Table: Choice with Uncertainty) Look at the table Choice with Uncertainty. Suppose
the probability that the sitcom does not make it to television is 50%, that it makes it to
television but is not the most viewed show in its time slot is 30%, and that it makes it to
television and is the most viewed show in its time slot is 20%. Given this information,
Norman, as a utility maximizer:
A)
should keep his teaching job.
B)
should quit his teaching job and go to Hollywood.
C)
will be indifferent between leaving and staying, because his expected income is the
same whether he stays a teacher or moves to Hollywood.
D)
will be indifferent between leaving and staying, because his expected total utility is
the same whether he stays a teacher or moves to Hollywood.
65.
(Table: Choice with Uncertainty) Look at the table Choice with Uncertainty. Assume
that the probability that the sitcom does not make it to television is 60%, the probability
that it makes it to television but is not the most viewed show in its time slot is 30%, and
the probability that it makes it to television and is the most viewed show in its time slot
is 10%. Norman’s expected income is:
A)
$52,500.
B)
$47,500.
C)
$40,000.
D)
$37,500.
66.
(Table: Choice with Uncertainty) Look at the table Choice with Uncertainty. Suppose
that the probability that the sitcom does not make it to television is 60%, the probability
that it makes it to television but is not the most viewed show in its time slot is 30%, and
that the probability that it makes it to television and is the most viewed show in its time
slot is 10%. Norman’s expected total utility is _____ utils.
A)
2,000
B)
2,150
C)
2,350
D)
2,650
Page 20
67.
(Table: Choice with Uncertainty) Look at the table Choice with Uncertainty. Suppose
the probability that the sitcom does not make it to television is 60%, that it makes it to
television but is not the most viewed show in its time slot is 30%, and that it makes it to
television and is the most viewed show in its time slot is 10%. As a utility maximizer,
Norman:
A)
should keep his teaching job.
B)
should quit his teaching job and go to Hollywood.
C)
will be indifferent between leaving and staying, because his expected income is the
same whether he stays a teacher or moves to Hollywood.
D)
will be indifferent between leaving and staying, because his expected total utility is
the same whether he stays a teacher or moves to Hollywood.
68.
(Table: Choice with Uncertainty) Look at the table Choice with Uncertainty. Suppose
the probability that the sitcom does not make it to television is 30%, that it makes it to
television but is not the most viewed show in its time slot is 50%, and that it makes it to
television and is the most viewed show in its time slot is 20%. Given this information,
Norman’s expected income is:
A)
$52,500.
B)
$47,500.
C)
$40,000.
D)
$37,500.
69.
(Table: Choice with Uncertainty) Look at the table Choice with Uncertainty. Suppose
the probability that the sitcom does not make it to television is 30%, that it makes it to
television but is not the most viewed show in its time slot is 50%, and that it makes it to
television and is the most viewed show in its time slot is 20%. Given this information,
Norman’s expected total utility is _____ utils.
A)
2,000
B)
2,150
C)
2,350
D)
2,650
Page 21
70.
(Table: Choice with Uncertainty) Look at the table Choice with Uncertainty. Suppose
the probability that the sitcom does not make it to television is 30%, that it makes it to
television but is not the most viewed show in its time slot is 50%, and that it makes it to
television and is the most viewed show in its time slot is 20%. Given this information,
Norman, as a utility maximizer:
A)
should keep his teaching job.
B)
should quit his teaching job and go to Hollywood.
C)
will be indifferent between leaving and staying, because his expected income is the
same whether he stays a teacher or moves to Hollywood.
D)
will be indifferent between leaving and staying, because his expected total utility is
the same whether he stays a teacher or moves to Hollywood.
Use the following to answer questions 71-74:
Scenario: Choosing Insurance
The Ramirez family owns three cars and is considering buying insurance to cover the cost of
repairs. They face two possible states: in state 1 their cars need no repairs and their income
available for purchasing other goods and services is $50,000; in state 2 their cars need $10,000
worth of repairs and their income available for purchasing other goods and services is reduced to
$40,000. The probability of repairs is 10%, while the probability of no repairs is 90%.
71.
(Scenario: Choosing Insurance) Refer to the information in the scenario Choosing
Insurance. For $2,000 the Ramirez family can buy insurance that will cover the full cost
of repairs. If family members are risk-averse and want to maximize their expected
utility:
A)
they will buy the insurance.
B)
they will be indifferent between buying and not buying the insurance, since their
expected income for purchasing other goods and services is $48,000 regardless of
what they do.
C)
they will buy the insurance as long as the utility of having a certain income of
$48,000 to buy goods and services other than car repairs is higher than the utility
associated with their expected income without insurance.
D)
they will self-insure.
Page 22
72.
(Scenario: Choosing Insurance) Refer to the information in the scenario Choosing
Insurance. For $1,000 the Ramirez family can buy insurance that will cover the full cost
of repairs. If family members are risk-averse and want to maximize their expected
utility:
A)
they will buy the insurance.
B)
they will be indifferent between buying and not buying the insurance, since their
expected income for purchasing other goods and services is $49,000, regardless of
what they do.
C)
they will buy the insurance as long as the utility of having a certain income of
$48,000 to buy goods and services other than car repairs is higher than the utility
associated with their expected income without insurance.
D)
they will self-insure.
73.
(Scenario: Choosing Insurance) Look at the scenario Choosing Insurance. The premium
on a fair insurance policy for the Ramirez family will be:
A)
$0.
B)
$900.
C)
$1,000.
D)
$2,000.
74.
(Scenario: Choosing Insurance) Refer to the information in the scenario Choosing
Insurance. For $900 the Ramirez family can buy insurance that will cover the full cost
of repairs. If family members are risk-averse and maximize their expected utility:
A)
they will buy the insurance.
B)
they will be indifferent between buying and not buying the insurance, since their
expected income for purchasing other goods and services is $49,100, regardless of
what they do.
C)
they will not buy the insurance, since buying it does not increase their expected
income for purchasing other goods and services.
D)
they will self-insure.
Page 23
Use the following to answer questions 75-77:
75.
(Table: Amy’s Utility Function) Look at the table Amy’s Utility Function. Amy is an
entrepreneur with income of $40,000. Amy is considering development of a new
product. The probability that her new product earns Amy $30,000 in additional income
is 0.5, and the probability that Amy incurs a reduction of $10,000 from her current
income is 0.5. Amy’s expected income after developing her new product is:
A)
$45,000.
B)
$35,000.
C)
$50,000.
D)
$60,000.
76.
(Table: Amy’s Utility Function) Look at the table Amy’s Utility Function. Amy is an
entrepreneur with current income equal to $40,000. Amy is considering development of
a new product. The probability that her new product earns Amy $30,000 in additional
income is 0.5, and the probability that Amy incurs a reduction of $10,000 from her
current income is also 0.5. Amy’s expected utility after developing her new product is
_____ utils.
A)
1,360
B)
860
C)
500
D)
680
Page 24
77.
(Table: Amy’s Utility Function) Look at the table Amy’s Utility Function. Amy is an
entrepreneur with current income equal to $40,000. Amy is considering development of
a new product. The probability that her new product earns Amy $10,000 in additional
income is 0.5, and the probability that Amy incurs a reduction of $10,000 from her
current income is also 0.5. Suppose Amy can buy a fair insurance policy that will
compensate her for any losses. Amy’s premium will be _____, her guaranteed income
will be _____, and her expected utility will be _____ utils.
A)
$5,000; $10,000; 200
B)
$10,000; $30,000; 500
C)
$10,000; $40,000; 620
D)
$30,000; $50,000; 720
78.
Consider the marginal utility of income curves of Hank, Babe, Barry, and Willie. Hank’s
is constant; Babe’s is slightly diminishing; Barry’s is strongly diminishing; and Willie’s
is upward-sloping. All else equal, which of these individuals will be most risk-averse?
A)
Hank
B)
Babe
C)
Barry
D)
Willie
79.
In an efficient allocation of risk:
A)
all risk is eliminated.
B)
those who are most willing to bear risk bear it.
C)
all risk is diversified.
D)
all insurance premiums are equal to the expected value of the claims.
80.
Mary and Bob are trying to decide how much auto insurance to buy. They share the
same expectations of an accident, with the same dollar loss. They also have the same
income levels. However, Mary would rather buy very little insurance, while Bob would
rather buy much more insurance. This suggests that:
A)
Bob is more risk-averse than Mary.
B)
Mary is more risk-averse than Bob.
C)
Bob is risk-averse and Mary is risk-loving.
D)
Mary is risk-averse and Bob is risk-loving.
81.
The total amount of funds that potentially could be paid out by an insurance company is:
A)
the sum of all premiums collected.
B)
the sum of all deductibles received from claims.
C)
the capital at risk.
D)
the company’s liabilities.
Page 25
82.
Suppose the wealth of buyers in the insurance market falls. We would expect insurance
premiums to _____ as the _____ curve shifts _____.
A)
rise; supply; left
B)
fall; supply; right
C)
fall; demand; left
D)
rise; demand; right
83.
Barcelona and Los Angeles are similar, except Barcelona has a good public
transportation system and Los Angeles does not. Auto insurance will probably be more
expensive in _____, since the _____ for insurance is _____.
A)
Barcelona; demand; higher than in Los Angeles
B)
Barcelona; supply; lower than in Los Angeles
C)
Los Angeles; demand; higher than in Barcelona
D)
Los Angeles; supply; lower than in Barcelona
84.
An efficient market for risk, such as an insurance market, is most likely to exist:
A)
when there is a level playing field, so that all participants have approximately the
same wealth and the same degree of risk aversion.
B)
when the sellers of insurance are risk-averse but the purchasers are not.
C)
when there are significant differences between individuals’ wealth levels and
attitudes toward risk.
D)
in the presence of private, or asymmetric, information.
85.
Which of the following is a principle of the insurance industry?
A)
Trade in risk can produce mutual gains.
B)
Diversification can increase risk.
C)
Deductibles add to the problem of moral hazard.
D)
Adverse selection should be used to reduce insurance costs.
86.
People who want to reduce the risk they face may pay other people who are less
sensitive to risk to take on some of their risk. As a result:
A)
a market for risk is illegal.
B)
trade in risk reduces mutual gains.
C)
total risk increases.
D)
people who are willing to accept more risk will purchase from people who are less
willing.
Page 26
87.
The funds that an insurance company may have to pay out are known as the:
A)
fair premium.
B)
capital at risk.
C)
total premium.
D)
deductible.
88.
Which of the following is TRUE if the insurance market is efficient?
A)
The deductibles eliminate moral hazard.
B)
Society as a whole engages in less risky behavior.
C)
It transfers risk from those who most want to get rid of it to those least bothered by
the risk.
D)
Premiums are always kept to the level of a fair insurance policy.
89.
If those who are most willing to bear risk end up bearing it, then we say that the
insurance market is:
A)
experiencing adverse selection.
B)
efficient.
C)
equitable.
D)
showing signs of moral hazard.
90.
As the premium for an insurance policy rises, there is a(n) _____ in the _____
insurance.
A)
decrease; demand for
B)
increase; supply of
C)
decrease; quantity demanded of
D)
decrease; supply of
91.
As the premium for an insurance policy falls, there is an increase in the _____
insurance.
A)
demand for
B)
supply of
C)
quantity demanded of
D)
quantity supplied of
92.
Why might the supply curve of insurance policies shift to the right?
A)
The wealth of the sellers of insurance increases.
B)
Premiums increase.
C)
Risk aversion increases.
D)
Diversification increases.
Page 27
93.
Assume that flood insurance premiums are determined in the competitive market.
Suppose that devastating floods along the Mississippi River have increased the degree
of risk aversion among the insurance investors in this market. The _____ insurance
shifts _____, leading to a(n) _____ in equilibrium premiums and a(n) _____ in the
quantity of insurance bought and sold.
A)
supply of; rightward; decrease; increase
B)
demand for; leftward; decrease; decrease
C)
supply of; leftward; increase; decrease
D)
demand for; rightward; increase; increase
94.
We would consider a tornado and a CEO scandal that hit a construction company on the
same day as _____ events.
A)
independent
B)
dependent
C)
premium
D)
probable
95.
Suppose the probability of a major theft at a hotel is 1%, while the probability of an
earthquake hitting the hotel is 2.3%. The probability that both would occur on the same
day is therefore:
A)
0.00023%.
B)
0.0023%.
C)
0.023%.
D)
2.3%.
Use the following to answer questions 96-97:
Scenario: Buying Shares
Geordie is considering buying shares in two companies, Apple and Microsoft. If he invests
$1,000 in Apple, there is a 40% probability that his investment will be worth only $800 and a
60% probability that it will be worth $1,200 at the end of a year. If he invests $500 in Apple,
there is a 40% probability that his investment will be worth $400 and a 60% probability that it
will be worth $600 at the end of a year. The corresponding numbers for investment in Microsoft
are identical.
Page 28
96.
(Scenario: Buying Shares) Look at the scenario Buying Shares. The probability that
Geordie will sustain a loss (i.e., that his investment at the end of the year will be worth
less than $1,000) is _____ if he invests $1,000 in either Apple or Microsoft and is _____
if he invests $500 apiece in Apple and in Microsoft.
A)
40%; 40%
B)
40%; 16%
C)
80%; 20%
D)
40%; 80%
97.
(Scenario: Buying Shares) Look at the scenario Buying Shares. The probability that
Geordie will make a gain is _____ if he invests $1,000 in either Apple or Microsoft. The
probability that he will make a gain is _____ if he invests $500 apiece in Apple and in
Microsoft.
A)
60%; 60%
B)
60%; 84%
C)
76%; 24%
D)
60%; 36%
98.
The strategy of reducing or eliminating risks by taking a small share in many
independent events or by taking advantage of the predictability associated with large
numbers of independent events is known as:
A)
floating.
B)
specializing.
C)
pooling.
D)
screening.
99.
Which pair of events is NOT independent?
A)
You forget your umbrella; it rains.
B)
There is a heat wave; demand for ice increases.
C)
You didn’t study last night; there is a quiz in your economics class.
D)
You don’t clean your apartment; you have unexpected company.
100.
On any particular day, the probability that it will rain is 25% and that you will be sick is
10%. The probability that both happen on the same day is:
A)
0.25%.
B)
1%.
C)
2.5%.
D)
17.5%.
Page 29
Use the following to answer questions 101-104:
Scenario: Diversification
Morris is considering investing $10,000 in a sunglass company or a rain poncho company. If it is
a rainy year and he invests only in the sunglass company, he will lose $5,000. However, if it is a
rainy year and he invests only in the rain poncho company, he will earn $10,000. If it is a sunny
year and he invests only in the sunglass company, he will earn $10,000; if he invests only in the
rain poncho company, he will lose $5,000 in a sunny year. There is a 50% chance of a sunny
year and a 50% chance of a rainy year.
101.
(Scenario: Diversification) Look at the scenario Diversification. If Morris invests all of
his money in the sunglass company, what is his expected gain or loss?
A)
a loss of $2,500
B)
to break even
C)
a gain of $2,500
D)
a gain of $10,000
102.
(Scenario: Diversification) Look at the scenario Diversification. If Morris invests all of
his money in the rain poncho company, what is his expected gain or loss?
A)
a loss of $2,500
B)
to break even
C)
a gain of $2,500
D)
a gain of $10,000
103.
(Scenario: Diversification) Look at the scenario Diversification. If Morris invests half of
his money in the sunglass company and half in the rain poncho company, what is his
expected gain or loss?
A)
a loss of $2,500
B)
to break even
C)
a gain of $2,500
D)
a gain of $10,000
104.
(Scenario: Diversification) Look at the scenario Diversification. If Morris invests half of
his money in the sunglass company and half in the rain poncho company, he will earn
_____ in a sunny year and _____ in a rainy year.
A)
$2,500; $0
B)
$1,250; $1,250
C)
–$2,500; $2,500
D)
$2,500; $2,500
Page 30
105.
If an insurance company insured 100,000 cars across the state against theft, which of the
following would NOT be true?
A)
The insurance company would be fairly certain of the number of cars that will be
stolen.
B)
The insurance company would be pooling risks.
C)
The insurance company would know with a fair amount of certainty the expected
payoff on the insurance policies.
D)
The insurance company must assume that very few cars will be stolen.
106.
An individual can almost eliminate risk by taking a small share in many independent
events or by taking advantage of the predictability associated with large numbers of
independent events. This is known as:
A)
specializing.
B)
floating.
C)
pooling.
D)
insuring.
107.
The strategy of investing in several assets so that any possible losses are independent
events is:
A)
diversification.
B)
private information.
C)
moral hazard.
D)
adverse selection.
108.
Which pair of events is likely to be positively correlated?
A)
stock prices of computer companies and of tire companies
B)
hurricane damage in Florida and earthquake damage in California
C)
sales of ice cream and cars on a hot summer day
D)
a week-long power outage due to a large hurricane and battery sales
109.
Investors in agricultural corporations face many correlated financial risks. Which of the
following are NOT correlated risks for the agricultural industry?
A)
losses due to drought and changes in the exchange rate with the euro
B)
political events that can lead to fewer crop subsidies and fewer milk supports
C)
recessions and changes in availability of credit
D)
the spread of genetically modified crops and the presence of locusts
Page 31
110.
If relevant events are _____, diversification will NOT reduce risk.
A)
positively correlated
B)
negatively correlated
C)
dependent
D)
independent
111.
Which of the following is a limit to the ability of diversification to reduce risk?
A)
losses due to bad decision making
B)
key raw materials
C)
industrial life cycles
D)
economic losses from bad weather
112.
At the end of the 1980s, Lloyd’s of London was in severe financial trouble because of:
A)
a major recession in Western Europe and the United States.
B)
terror attacks by the IRA.
C)
asbestos claims.
D)
the war in Iraq.
113.
The opportunity to engage in pooling shifts the _____ curve of insurance to the right;
insurance companies will take on _____ risk and charge a _____ premium than without
pooling.
A)
supply; more; lower
B)
demand; more; lower
C)
supply; less; higher
D)
demand; less; higher
114.
Asymmetric, or private, information:
A)
is an important explanation of the variation (or asymmetric performance) of
individuals on standardized tests.
B)
refers to personal information (e.g., regarding gender or ethnicity) that a person is
not obligated to reveal on a job application.
C)
is relevant for an economic transaction and is known only by some of the people
involved in the transaction.
D)
is protected by patents or copyrights.
Page 32
115.
When some people know things that other people don’t know, there is _____; it can
_____ economic decisions.
A)
risk aversion; facilitate
B)
blind strategy; delay
C)
private information; distort
D)
blind trust; diversify
116.
A life insurance company will often require an applicant to submit to a brief physical
exam to assess that person’s basic level of health. This practice is a form of _____ to
lessen the problem of _____.
A)
diversification; moral hazard
B)
signaling; deductibles
C)
reputation; adverse selection
D)
screening; adverse selection
117.
The problem of adverse selection:
A)
occurs when sellers (who know more than buyers about the quality of the product)
deliberately select inferior products to sell.
B)
is also referred to as the moral hazard problem.
C)
can result in an overall increase in the gains from trade.
D)
occurs when an employer fires the wrong person.
118.
In which of the following situations is adverse selection most likely to be a problem?
A)
buying tomatoes at the local farmers’ market
B)
hiring a new manager to work the night shift
C)
buying a new lawnmower
D)
buying a house directly from the previous owner
119.
People faced with adverse selection use _____ to deal with it.
A)
screening
B)
signals
C)
reputation
D)
screening, signals, and reputation
120.
_____ is (are) a strategy(ies) for dealing with adverse selection in the labor market.
A)
Careful screening of an applicant
B)
Examination of signals from an applicant
C)
Obtaining reference letters from an applicant’s previous place of employment
D)
Careful screening of an applicant, examination of signals from an applicant, and
obtaining reference letters from an applicant’s previous place of employment
Page 33
121.
Companies offering life insurance often require a drug test to determine whether the
buyer is a smoker. A smoker must pay a higher premium. This is an example of:
A)
providing the buyer with a personal stake, a way of dealing with moral hazard.
B)
screening to deal with adverse selection.
C)
the demand curve shifting right because of an increase in risk.
D)
pooling of risk with others.
122.
In practice, insurance companies faced with adverse selection use _____ to deal with it.
A)
moral hazard
B)
deductibles
C)
signals
D)
co-pays
123.
Private information leads _____ to expect hidden problems in items offered for sale,
leading to _____ prices and to the best items being kept off the market.
A)
buyers; high
B)
buyers; low
C)
sellers; high
D)
sellers; low
124.
Rhonda would like a better bicycle, and she considers selling her old one by advertising
on the bulletin board in the student center. She decides against it because the used
bicycles listed on the board are underpriced. This describes the problem of:
A)
adverse selection.
B)
moral hazard.
C)
positive correlation.
D)
risk aversion.
125.
Sellers of used cars may have private information to which buyers are not privy. This
leads to all of the following EXCEPT:
A)
lower prices for the cars.
B)
a shortage of used cars on the market.
C)
many mutually beneficial transactions not taking place.
D)
potential sellers willing to sell only at high prices.
Page 34
126.
Used-car dealers will often advertise how long they have been in business as a means of
_____ their long-term _____.
A)
signaling; reputation
B)
screening; customers
C)
insuring; capital at risk
D)
revealing; moral hazard
127.
Moral hazard occurs when individuals:
A)
do not do what is in their own best interest.
B)
know more about acceptable business behavior than other people do.
C)
have an incentive to violate their morals.
D)
know more about their actions than other people do.
128.
Many people smoke and continue poor eating habits because they have health insurance.
This is an example of:
A)
moral hazard.
B)
signaling.
C)
reputation.
D)
adverse selection.
129.
Moral hazard:
A)
occurs when incentives are distorted because an individual knows more about his
or her own actions than other people do.
B)
is a term used to describe the bonuses paid for particularly hazardous jobs (such as
firefighting).
C)
is a term used synonymously with value judgment.
D)
refers to the questionable morality of price gouging in hazardous times (e.g., in the
presence of famines or floods).
130.
Solutions to moral hazard include:
A)
offering salespeople in stores a straight salary rather than a commission on sales.
B)
setting up many stores and restaurants that are part of a national chain as
franchises, with the owner undertaking quite a lot of risk.
C)
allowing property owners to overinsure their buildings.
D)
diversification.
Page 35
131.
Insurance companies deal with the problems of moral hazard by:
A)
always insuring buildings for their full replacement value.
B)
refusing to insure commercial properties against losses caused by fire.
C)
requiring a deductible to provide an incentive for insured individuals to take
reasonable precautions to avoid losses.
D)
charging extra in cases of adverse selection.
132.
Health insurance policies include deductibles:
A)
to minimize moral hazard.
B)
because when it comes to health, most people are risk-averse.
C)
to minimize adverse selection.
D)
because many health insurance companies own hospitals.
133.
You insure your car against theft. Consequently, you rarely lock the car. This describes
the problem of:
A)
adverse selection.
B)
moral hazard.
C)
positive correlation.
D)
risk aversion.
134.
The premium on insurance is often _____ to the deductible, allowing insurance
companies to _____ their customers.
A)
equal; pool
B)
directly related; signal
C)
equal; offer a fair premium to
D)
inversely related; screen
135.
Fire insurance policies include deductibles:
A)
because when it comes to fire, most people are risk-averse.
B)
because it is too expensive to fully insure something against fire.
C)
to minimize moral hazard.
D)
to minimize adverse selection.
136.
Insurance companies attempt to minimize moral hazard by imposing:
A)
premiums.
B)
capital at risk.
C)
adverse selection.
D)
deductibles.
Page 36
137.
McDonald’s and other fast-food chains rely mainly on franchisees to operate the
restaurants to avoid the problem of:
A)
adverse selection.
B)
moral hazard.
C)
insurance.
D)
deductibles.
138.
By offering a menu of policies with different premiums and deductibles, insurance
companies can _____ their customers; for example, a low-risk customer will often buy
insurance with a lower _____ but a higher _____ than a high-risk customer.
A)
signal; deductible; premium
B)
signal; premium; deductible
C)
screen; deductible; premium
D)
screen; premium; deductible
139.
A random variable has a certain future value.
A)
True
B)
False
140.
The future price of one share of General Motors stock is a random variable.
A)
True
B)
False
141.
You go into a grocery store to buy a soft drink. You find that different brands or
varieties have different prices: for a one-liter bottle, Coke costs $1, Pepsi costs $0.95,
and ginger ale costs $1.05. The price of a one-liter bottle of a soft drink at your grocery
store is therefore a random variable.
A)
True
B)
False
142.
The Baker family is faced with two possible states. In state 1, they remain healthy and
incur no medical expenses. In state 2, their medical expenses will be $8,000. There is a
30% chance that state 1 will occur and a 70% chance that state 2 will occur. An
insurance company offers to pay all of their medical expenses for a premium of $6,000.
From the Bakers’ point of view, this is a fair insurance policy.
A)
True
B)
False
Page 37
143.
Jill is a risk-averse expected-utility maximizer. Jack offers her the following bet: he will
toss a coin and pay her $5 if it comes down heads, but if it comes down tails, Jill will
have to pay him $5. Even though heads and tails are equally likely, Jill will not take the
bet.
A)
True
B)
False
144.
A fair insurance policy is one in which the premium equals the expected value of the
claim.
A)
True
B)
False
145.
Risk-averse individuals are willing to make deals that reduce their income to reduce
their risk.
A)
True
B)
False
146.
The wealthy are generally more risk-averse than the poor, since the wealthy have more
to lose.
A)
True
B)
False
147.
A person who has a constant marginal utility of income will be risk-averse.
A)
True
B)
False
148.
The existence of a large and growing gambling industry clearly shows that many people
are risk-loving.
A)
True
B)
False
149.
Through insurance and other devices, the modern economy offers many ways for
individuals to reduce their exposure to risk.
A)
True
B)
False
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150.
Risk-averse individuals will always buy insurance, regardless of the premiums charged.
A)
True
B)
False
151.
Buying a warranty on a new television is an example of paying to avoid risk.
A)
True
B)
False
152.
An efficient allocation of risk occurs when those most willing to bear risk insure those
who are least willing to bear risk.
A)
True
B)
False
153.
Two possible events are independent if they happen at different times and in different
places.
A)
True
B)
False
154.
The easiest risks to reduce by diversification are those associated with positively
correlated events.
A)
True
B)
False
155.
Private information can cause economic inefficiency by preventing mutually beneficial
transactions.
A)
True
B)
False
156.
Common strategies to deal with the problem of adverse selection include screening
(using observable information to make inferences about private information), signaling
(engaging in actions that reveal one’s private information), and establishing a good
reputation.
A)
True
B)
False
157.
Moral hazard occurs only when people fail to do what is in their best interest.
A)
True
B)
False
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158.
Adverse selection and moral hazard do not affect the efficiency of the market.
A)
True
B)
False
159.
You have one ticket for a raffle with a grand prize of $1,000. There are two prizes worth
$100 and five prizes worth $20. If only 100 tickets have been distributed, what is the
expected value of your winnings?
160.
You are risk-neutral. You are considering the purchase of a $10 ticket for a raffle with a
grand prize of $1,000. There are two prizes worth $100 and five prizes worth $20. If
you know that only 100 tickets will be sold, should you purchase the ticket?
161.
You are considering the purchase of one ticket for a raffle with a grand prize of $1,000.
There are two prizes worth $100 and five prizes worth $20. If you know that only 100
tickets will be sold, what is the most you would pay for one raffle ticket?
162.
Jaleh has just landed a great job and plans to buy a fancy car worth $100,000. Jaleh is
otherwise risk-averse, but she likes to drive fast, so the probability that she wrecks the
car (a total loss of $100,000) is 0.1. The probability that she has no accidents is 0.9. If
an insurance company were to offer Jaleh a fair insurance policy that completely
replaced her car, how much would she pay? What is the most she would pay for an
insurance policy that would completely replace her car if she totaled it?
Use the following to answer question 163:
163.
(Table: Crop Income) Look at the table Crop Income. Brent is a farmer, and his income
depends on the weather.
A) Calculate Brent’s expected income.
B) Calculate Brent’s expected utility.
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164.
Most college-bound high school seniors apply for admission to several colleges of
varying reputations and admission standards. Explain how this behavior is similar to
diversification of assets discussed in the chapter.
165.
The seller of a product will sometimes offer a warranty that if the product is defective,
the seller will repair or replace it free of charge within a specified time. What is the role
of product warranties in lessening the problem of asymmetric information (or private
information) and increasing the number of transactions that are made?
166.
Two consumers go to the insurance company to purchase life insurance. James is a
smoker and a police officer who races motorcycles in his spare time. Kathy is a
nonsmoker and a librarian who likes to make quilts in her spare time. The insurance
company knows that both consumers are 40 years old, but the company has no
information about occupations or hobbies. How does the private information in this
situation set up an adverse-selection problem? How could the insurance company lessen
this problem?
167.
You own a shoe store and need a new sales associate. You have a large stack of
applications, but unfortunately you have no idea who is a strong salesperson and who is
a weak one. What kind of problem are you facing and how can you solve it?
168.
Newman has decided to take a road trip in a rental car. He has the minimum amount of
personal car insurance to rent the car, but he decides to pay a little extra to the rental car
company to completely insure himself against any damage to the rental car. How is
there a potential moral hazard due to Newman’s purchase of the additional insurance?
Use the following to answer questions 169-171:
Scenario: Health Costs
Alan is hoping for a healthy year, meaning that he would have zero health costs. Given his
habits, there is a 40% chance that Alan will develop a health issue resulting in $50,000 in health
costs. Assume these are the only two conditions that could exist for Alan in the coming year.
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169.
(Scenario: Health Costs) Look at the scenario Health Costs. Given the fact that Alan has
a 40% chance of developing a health problem, what is the expected value of Alan’s
health care costs for the coming year?
A)
$0
B)
$50,000
C)
$20,000
D)
$16,000
170.
(Scenario: Health Costs) Look at the scenario Health Costs. Suppose that Alan decides
to change his habits dramatically and as a result decreases the probability of his
developing a health problem such that he now has a 20% chance of becoming ill. What
is the expected value of Alan’s health costs now?
A)
$0
B)
$10,000
C)
$20,000
D)
$2,000
171.
(Scenario: Health Costs) Look at the scenario Health Costs. When Alan’s probability of
developing a health problem decreases, holding everything else constant, Alan’s
expected value of health care costs:
A)
increases.
B)
decreases.
C)
stays constant.
D)
increases, decreases, or stays constant.
172.
If the probability that one person will develop a health problem is greater than that of
another person and if they buy insurance from the same provider, most likely the person
with a higher probability will pay:
A)
the same as the other person.
B)
more than the person with the lower probability.
C)
less than the person with the lower probability.
D)
All people, regardless of probabilities, pay the same amount for insurance.
173.
An individual finds that as his income increases, his total utility also increases but at a
decreasing rate. This can be attributed to:
A)
diminishing marginal utility.
B)
being risk-neutral.
C)
expected values.
D)
efficient allocation of risk.
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174.
Given uncertainty, individuals attempt to maximize their:
A)
adverse selection.
B)
expected utility.
C)
risk aversion.
D)
consumption.
175.
Suppose for the coming year a family has calculated its expected value for car repairs to
be $3,000. The family decides to buy a car insurance policy that would cover such
claims. This insurance policy would cost a total of $3,000 for the household. This
insurance policy is:
A)
overcharging the family and is not fair.
B)
an example of a fair insurance policy.
C)
undercharging the family.
D)
not appropriate for the family, and they should not buy it.
176.
Organized-gambling venues such as those at Las Vegas tend to attract:
A)
risk-loving individuals only.
B)
even risk-averse people because they are designed to allow individuals to win.
C)
people who may be irrational in their choice of gambling and are often risk-averse.
D)
only professional gamblers.
177.
Lucy decides to buy car insurance because:
A)
she wishes to increase her exposure to risk.
B)
she wants to decrease her exposure to risk.
C)
she is not risk-averse.
D)
her marginal utility is not strongly dependent upon her income.
178.
Risk-averse individuals:
A)
will not gamble at casinos such as those found in Las Vegas.
B)
will pay higher insurance premiums based on their risk aversion.
C)
are a minority of the population.
D)
have upward-sloping marginal utility functions.
179.
Warranties that cover the cost of a repair or replacement will:
A)
decrease the consumer’s expected utility from consuming the good.
B)
increase the consumer’s expected utility from consuming the good.
C)
have no impact on the consumer’s expected utility from consuming the good.
D)
reverse the consumer’s diminishing marginal utility.
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180.
When Lloyd’s of London offered to provide insurance to merchant ships in the
eighteenth century, Lloyd’s was:
A)
exhibiting risk-averse behavior.
B)
less sensitive to risk than those who requested insurance.
C)
attempting to decrease its exposure to risk.
D)
not very rational in its behavior.
181.
_____ of insurance are often risk-averse, and _____ of insurance are interested in
reducing their exposure to risk.
A)
Demanders; suppliers
B)
Demanders; demanders
C)
Suppliers; demanders
D)
Suppliers; suppliers
Use the following to answer questions 182-183:
Scenario: Flood Area
Suppose you own a home that is estimated to be worth $250,000. You live in a flood plain; as a
result, the probability that you will lose your home to a flood is 30%.
182.
(Scenario: Flood Area) Look at the scenario Flood Area. A flood may occur, causing
you to lose your entire home. In this case, your expected loss resulting from the flood
would be:
A)
$250,000.
B)
$75,000.
C)
$15,000.
D)
$100,000.
183.
(Scenario: Flood Area) Look at the scenario Flood Area. Suppose an insurance company
offers you flood insurance. Most likely this insurance would require a premium
payment:
A)
greater than $250,000.
B)
greater than $75,000.
C)
less than $15,000.
D)
equal to $100,000.
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184.
In a particular insurance market, there is a decrease in the degree of risk aversion among
buyers. Holding everything else constant, the equilibrium premium will _____ and the
equilibrium quantity of insurance will _____.
A)
increase; increase
B)
decrease; decrease
C)
increase; decrease
D)
decrease; increase
185.
In a particular insurance market, there is a decrease in the degree of risk aversion among
suppliers. Holding everything else constant, the equilibrium premium will _____ and
the equilibrium quantity of insurance will _____.
A)
increase; increase
B)
decrease; decrease
C)
increase; decrease
D)
decrease; increase
186.
As a result of frequent flooding, the insurance market has noted a positive correlation
between flooding and the amount of insurance monies paid out for such floods. Holding
demand for insurance constant, if flooding is expected to continue to be a problem,
flood insurance premiums will most likely:
A)
rise.
B)
fall.
C)
stay the same.
D)
rise, fall, or stay the same.
187.
Suppose a person rolls a typical six-sided die. What is the probability that the die will
come up with a 1 two times in a row?
A)
1 in 6
B)
1 in 3
C)
1 in 36
D)
1 in 12
188.
Suppose a person rolls a typical six-sided die. What is the probability that the die will
come up with a 1 and then a 2?
A)
1 in 3
B)
1 in 36
C)
1 in 6
D)
2 in 5
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189.
Two individuals make up the auto insurance market. Bonnie drives well, and the
probability of her having an accident is 10% this year. Lisa also drives carefully, and her
probability of having an accident is 5%. What is the probability that Bonnie and Lisa
will both have accidents this year?
A)
0.15%
B)
0.75%
C)
0.005%
D)
0.5%
190.
The pooling of risk is a _____ form of diversification that produces a payoff with a very
_____ risk.
A)
weak; large
B)
weak; small
C)
strong; large
D)
strong; small
191.
Economic growth that is not industry-specific is most likely to:
A)
have no effect on most businesses.
B)
result in many businesses doing well.
C)
result in many businesses not doing well.
D)
affect only a few select businesses.
192.
As a result of frequent flooding, the insurance market has noted a positive correlation
between flooding and the amount of insurance monies paid out for such floods. Holding
demand for insurance constant, if flooding is expected to continue to be a problem:
A)
flood insurance providers will reap greater profits.
B)
more insurance companies will provide such insurance.
C)
flood insurance markets may eventually collapse, since the risks of damage cannot
be offset by diversification.
D)
flood insurance premiums will decrease.
193.
As a result of frequent flooding, the insurance market has noted a positive correlation
between flooding and the amount of insurance monies paid out for such floods.
Moreover, the probability of such flooding has been increasing. As a result,
homeowners in flood plains will find flood insurance:
A)
easy to acquire and relatively inexpensive.
B)
very costly and relatively difficult to find.
C)
premiums have not changed, since the insurance continues to offer the same
coverage.
D)
relatively expensive but easy to acquire.
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194.
The insurance industry operates on the principles of:
A)
risk trading and diversification.
B)
exploitation and capital accumulation.
C)
moral hazard and irrationality.
D)
adverse selection and diminishing marginal utility.
195.
Toyotas are known for their quality and durability. As a result, compared to other used
car markets, adverse selection in the used Toyota market is:
A)
equally likely.
B)
relatively unlikely.
C)
more likely.
D)
not expected.
196.
When an individual knows more about his or her own actions than other people do,
incentives are distorted, which causes:
A)
moral hazard.
B)
adverse selection.
C)
screening.
D)
signaling.
197.
Moral hazard:
A)
increases the ability of markets to allocate risk efficiently.
B)
decreases the ability of markets to allocate risk efficiently.
C)
has no impact on the ability of markets to allocate risk efficiently.
D)
encourages the provision of 100% insurance coverage.
198.
Moral hazard can be reduced by:
A)
the use of 100% insurance coverage.
B)
imposing a deductible on insurance coverage.
C)
taking away personal stakes for people with private information.
D)
offering fewer incentives to people with private information to act in a less risky
manner.
199.
Insurance premiums often fall substantially if a buyer purchases a policy with a high
deductible, and such a policy is often purchased by individuals who self-identify as:
A)
low-risk drivers.
B)
high-risk drivers.
C)
drivers who do not care what their premium costs are.
D)
neither high- nor low-risk drivers.
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Use the following to answer questions 200-202:
Scenario: Used Car Market
In the used car market, cars of poor quality are called lemons, while cars of good quality are
plums. Suppose the probability of obtaining a lemon is 60% and the probability of obtaining a
plum is 40%. Also assume a plum is worth $15,000 and a lemon is worth $3,000.
200.
(Scenario: Used Car Market) Look at the scenario Used Car Market. The expected value
of a used car is:
A)
$9,000.
B)
$7,800.
C)
$18,000.
D)
$10,500.
201.
(Scenario: Used Car Market) Look at the scenario Used Car Market. If buyers cannot
distinguish between lemons and plums, eventually this used car market will:
A)
be made up mostly of lemons.
B)
have buyers who will have a 50% chance of choosing a plum.
C)
be made up mostly of plums.
D)
be made up of 50% plums and 50% lemons.
202.
(Scenario: Used Car Market) Look at the scenario Used Car Market. Adverse selection
in this used car market occurs because of:
A)
asymmetric information.
B)
risk-loving behavior.
C)
moral hazard.
D)
diversification.
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