Question 1

The existence of a large and growing gambling industry clearly shows that many people are risk-loving.

Accepted Answer

The existence of a large and growing gambling industry does not necessarily indicate that many people are risk-loving; it can also suggest that people are seeking entertainment, are hopeful for large payouts despite the odds, or are influenced by cognitive biases that distort their perception of risk.

Question 2

Two possible events are independent if they happen at different times and in different places.

Accepted Answer

Independence refers to the occurrence of one event not being related or influenced by the occurrence of another event. The timing and physical location of the events do not necessarily determine their independence. Two events can occur at the same time and place and still be independent if they are not related in any way. Likewise, two events that occur at different times and places can be dependent if they are related or influenced by each other.

Question 3

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.

Accepted Answer

This statement is true. These are all common strategies used to mitigate the effects of adverse selection in various settings, especially in markets where information asymmetry between buyers and sellers can lead to unfavorable outcomes.

Question 4

Private information can cause economic inefficiency by preventing mutually beneficial transactions.

Accepted Answer

When private information is present, it can lead to asymmetric information where one party knows more than the other. This can create inefficiency by preventing mutually beneficial transactions from taking place. For example, a seller who knows their product is high quality may not be able to signal this to buyers, leading to lower demand and a lower price. This can result in a deadweight loss and reduced economic efficiency.

Question 5

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?

Accepted Answer

The answer of You are risk-neutral. You are considering the...

Question 6

The wealthy are generally more risk-averse than the poor, since the wealthy have more to lose.

Accepted Answer

Research has shown that the opposite is true; poorer individuals tend to be more risk-averse than wealthier individuals because they have less financial cushion to fall back on in case of a loss. The wealthy may be more willing to take risks because they have more resources to absorb a potential loss.

Question 7

Buying a warranty on a new television is an example of paying to avoid risk.

Accepted Answer

Buying a warranty on a new television is a way to avoid the risk of having to pay for repairs or replacement if something goes wrong with the TV. By paying for the warranty upfront, the buyer can avoid potential future costs and protect themselves from financial loss.

Question 8

Risk-averse individuals are willing to make deals that reduce their income to reduce their risk.

Accepted Answer

Risk-averse individuals are more concerned with minimizing risks than maximizing rewards, so they are willing to give up some income in exchange for a lower level of risk.

Question 9

Risk-averse individuals will always buy insurance, regardless of the premiums charged.

Accepted Answer

Risk-averse individuals will consider the premiums charged when deciding whether to buy insurance or not. If the premiums are too high, they may choose to take their chances without insurance.

Question 10

A fair insurance policy is one in which the premium equals the expected value of the claim.

Accepted Answer

A fair insurance policy is one in which the premium charged by the insurer equals the expected value of the claim. This means that on average, the insurer will break even and neither the insurer nor the insured will gain an unfair advantage.

Question 11

An efficient allocation of risk occurs when those most willing to bear risk insure those who are least willing to bear risk.

Accepted Answer

This is because those who are most willing to bear risk will be willing to pay a higher premium to insure those who are less willing to bear risk. This leads to a fair allocation of risk where everyone's preferences are taken into account.

Question 12

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?

Accepted Answer

The answer of You have one ticket for a raffle...

Question 13

Through insurance and other devices, the modern economy offers many ways for individuals to reduce their exposure to risk.

Accepted Answer

Insurance and other risk management tools such as diversification and hedging are widely available in the modern economy to help individuals mitigate their exposure to risk.

Question 14

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.

Accepted Answer

The price of a one-liter bottle of a soft drink is not a random variable in this context because the prices are fixed and known for each brand or variety, not determined by chance.

Question 15

The easiest risks to reduce by diversification are those associated with positively correlated events.

Accepted Answer

Diversification is most effective at reducing risks associated with uncorrelated or negatively correlated events, as the negative performance of some investments can be offset by the positive performance of others.

Question 16

Moral hazard occurs only when people fail to do what is in their best interest.

Accepted Answer

Moral hazard occurs when people have an incentive to take risks or behave in a way that is not in their best interest because they know they will not bear the full consequences of their actions. It is not limited to situations where people fail to act in their best interest.

Question 17

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.

Accepted Answer

The expected value of the medical expenses without insurance is:
0.3 x $0 + 0.7 x $8,000 = $5,600
The expected value of the total cost with insurance is:
0.3 x $6,000 + 0.7 x ($6,000 - $8,000) = $1,000
Therefore, the insurance policy is not fair from the Bakers' point of view as they would end up paying more for insurance than the expected value of the medical expenses without insurance.

Question 18

A person who has a constant marginal utility of income will be risk-averse.

Accepted Answer

A person with constant marginal utility of income is indifferent to risk, as their satisfaction from each additional unit of income remains the same regardless of the amount of income they have. Risk aversion is characterized by a decreasing marginal utility of income.

Question 19

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.

Accepted Answer

Since Jill is risk-averse, she will not take a bet with a negative expected value. The expected value of this bet is zero, but there is a risk of losing $5, which Jill is not willing to take. Therefore, she will not take the bet.

Question 20

Adverse selection and moral hazard do not affect the efficiency of the market.

Accepted Answer

Adverse selection and moral hazard can lead to market inefficiencies by causing market failures such as asymmetric information and principal-agent problems. These can result in a misallocation of resources and market inefficiencies. Therefore, adverse selection and moral hazard do affect the efficiency of the market.

Quiz 20: Uncertainty, Risk, and Private Information