Question 1

People faced with adverse selection use _____ to deal with it.
A) screening
B) signals
C) reputation
D) screening,signals,and reputation

Accepted Answer

Adverse selection refers to the situation where one party has more information than the other party in a transaction, which leads to higher risk and potential losses for the party with less information. To deal with adverse selection, people can use screening, which is a process of gathering information about the other party to reduce the information asymmetry. They can also use signals, which are actions or attributes that indicate the quality or reliability of the other party. Additionally, reputation is another way to deal with adverse selection, as people tend to trust those who have a good reputation and a history of trustworthy behavior. Therefore, the best choice is option D as all three strategies can be used to deal with adverse selection.

Question 2

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.

Accepted Answer

Lloyd's of London was hit hard by asbestos claims in the late 1980s, with payouts totaling over £1 billion. This, along with other factors like poor management and underwriting practices, led to the near-collapse of the insurance market.

Question 3

Which strategy is NOT used for dealing with adverse selection in the labour 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) openly asking candidates of any hidden work problems from their past

Accepted Answer

Openly asking candidates of any hidden work problems from their past is not a common strategy for dealing with adverse selection in the labour market. This approach may not yield honest answers from the candidates, and it may also create a legal risk for the employer as some past work-related issues may be protected under privacy laws. The other three strategies - careful screening, examination of signals, and obtaining reference letters - are commonly used to mitigate adverse selection by gathering information about the candidate's skills, experience, and work history.

Question 4

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.

Accepted Answer

Diversification is the strategy of investing in different assets that do not move together, so losses in one do not always mean losses in the others. This helps to reduce the overall risk of the investment portfolio. Private information, moral hazard, and adverse selection are not related to this strategy of diversification.

Question 5

Which pair of events is likely to be positively correlated?
A) stock prices of computer companies and of tire companies
B) flood damage in Quebec and forest fire damage in British Colombia
C) sales of ice cream and cars on a hot summer day
D) a week-long power outage due to a large ice storm and battery sales

Accepted Answer

A week-long power outage due to a large ice storm is likely to increase battery sales as people seek alternative power sources, indicating a positive correlation.

Question 6

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.

Accepted Answer

The requirement of a drug test to determine whether the buyer is a smoker is a form of screening, which helps the insurance company deal with adverse selection. Smokers have a higher risk of health problems and therefore are more likely to make claims on their life insurance policy, making it necessary for the insurance company to charge them a higher premium. This helps to prevent non-smokers from subsidizing the costs of smokers, who pose a higher risk to the insurance company.

Question 7

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) signalling;deductibles
C) reputation;adverse selection
D) screening;adverse selection

Accepted Answer

The practice of requiring a physical exam is a form of screening, which helps to identify individuals who may have greater health risks and are more likely to file claims, thereby reducing the problem of adverse selection.

Question 8

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.

Accepted Answer

Adverse selection is a problem that arises when one party (in this case, the seller) has more information than the other party (buyer) and uses it to their advantage by selling inferior products. This can lead to a decrease in overall gains from trade as buyers may be unwilling to purchase due to a lack of trust in the seller's products. Moral hazard, on the other hand, refers to the problem of a party taking risks because they are not fully responsible for the consequences of their actions. Firing the wrong person is an example of a mistake, not adverse selection.

Question 9

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

Accepted Answer

Pooling shifts the supply curve of insurance to the right because more people are willing to buy insurance when they can pool their risk together. Insurance companies will take on more risk because the larger pool of insured individuals reduces their overall risk. As a result, they can charge a lower premium than without pooling.

Question 10

Which factor 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

Accepted Answer

The answer of Which factor is a limit to the...

Question 11

If relevant events are _____,diversification will NOT reduce risk.
A) positively correlated
B) negatively correlated
C) dependent
D) independent

Accepted Answer

When events are positively correlated, diversification will not reduce risk as all events will move in the same direction. Diversification works best when events are negatively or not correlated at all, as the losses in one event can be offset by gains in another. Dependent and independent events are not relevant factors for determining the effectiveness of diversification.

Question 12

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.

Accepted Answer

Asymmetric information refers to situations where some people involved in an economic transaction have access to information that others do not. This can lead to inefficiencies and market failures.

Question 13

Use the following to answer questions :
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.
-(Scenario: Diversification)Use 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

Accepted Answer

The answer of Use the following to answer questions :
Scenario:...

Question 14

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

Accepted Answer

Private information refers to information that is only known to a particular individual or group of individuals. When this information is not shared equally, it can lead to distortions in economic decisions. For example, if some investors have insider information about a company's future profits, they may make investment decisions that give them an unfair advantage over other investors who are not privy to this information. This can lead to market inefficiencies and undermine the fairness and transparency of the economic system. Therefore, C is the best choice. A, B, and D do not accurately describe the situation of private information and its impact on economic decisions.

Question 15

Investors in agricultural corporations face many correlated financial risks.Which example does NOT illustrate 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

Accepted Answer

The spread of genetically modified crops and the presence of locusts do not have a direct correlation with each other or with other financial risks in the agricultural industry. The other examples given all have clear correlations with other financial risks, such as drought affecting crop yields and changes in exchange rates affecting export profits.

Question 16

If an insurance company insured 100 000 cars across the province against theft,which statement 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.

Accepted Answer

The statement "The insurance company must assume that very few cars will be stolen" is not true. In fact, the insurance company must assume that a certain percentage of cars will be stolen and use statistical analysis to determine the expected number of thefts and the corresponding premium to charge each policyholder.

Question 17

In which situation 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

Accepted Answer

Adverse selection is most likely to be a problem when buying a house directly from the previous owner because the seller has more information about the property's condition than the buyer, potentially leading to the buyer making a poor decision based on incomplete information.

Question 18

Use the following to answer questions :
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.
-(Scenario: Diversification)Use 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

Accepted Answer

If Morris invests $5,000 in the sunglass company and $5,000 in the rain poncho company, then his expected gain or loss would be:

- In a rainy year: (0.5 x $10,000) - (0.5 x $5,000) = $2,500 gain.
- In a sunny year: (0.5 x $10,000) - (0.5 x $5,000) = $2,500 gain.

Therefore, his expected gain would be $2,500 regardless of the weather conditions. This is the best choice because it minimizes the potential risk of losing money in case of a rainy or sunny year.

Question 19

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 strategy is known as:
A) specializing.
B) floating.
C) pooling.
D) insuring.

Accepted Answer

The strategy of taking small shares in many independent events or taking advantage of predictability associated with large numbers of independent events is known as pooling. This allows an individual to spread out their risk and reduce the likelihood of a catastrophic event affecting their entire investment. This strategy is commonly used in insurance, where a large number of individuals pool their resources to protect against a specific risk. The other options, specializing, floating, and insuring, do not accurately describe this strategy.

Question 20

Use the following to answer questions :
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.
-(Scenario: Diversification)Use 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

Accepted Answer

By diversifying his investment and investing in both companies, Morris will earn $2 500 in a sunny year ($10 000 earned from sunglass company - $5 000 lost from the rain poncho company) and $2 500 in a rainy year ($10 000 earned from the rain poncho company - $5 000 lost from the sunglass company). This is a better option than investing all of his money in one company and potentially losing money in a year where that company performs poorly.

Quiz 20: Uncertainty, risk, and Private Information

People faced with adverse selection use _____ to deal with it.

At the end of the 1980s,Lloyd's of London was in severe financial trouble because of:

Which strategy is NOT used for dealing with adverse selection in the labour market?

The strategy of investing in several assets so that any possible losses are independent events is:

Which pair of events is likely to be positively correlated?

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 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 _.

The problem of adverse selection:

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.

Which factor is a limit to the ability of diversification to reduce risk?

If relevant events are _____,diversification will NOT reduce risk.

Asymmetric,or private,information:

When some people know things that other people don't know,there is _;it can _ economic decisions.

Investors in agricultural corporations face many correlated financial risks.Which example does NOT illustrate correlated risks for the agricultural industry?

If an insurance company insured 100 000 cars across the province against theft,which statement would NOT be true?

In which situation is adverse selection MOST likely to be a problem?

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 strategy is known as: