Question 1

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) 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

Accepted Answer

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

Question 2

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

Accepted Answer

The answer of In which of the following situations is...

Question 3

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 a situation where one party involved in an economic transaction has more information than the other party. This can lead to adverse selection or moral hazard problems. Asymmetric information is only known by some of the people involved in the transaction, which makes it difficult for the uninformed party to make an optimal decision.

Question 4

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

Accepted Answer

Diversification works best when events are negatively or not correlated at all, meaning that they move independently of each other. If events are positively correlated, then they tend to move in the same direction, which means diversification will not be effective in reducing risk.

Question 5

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 a strategy that involves investing in several assets so that any possible losses are independent events. This reduces the overall risk of the portfolio because losses in one asset can be offset by gains in another. Private information, moral hazard, and adverse selection are not related to this particular investing strategy.

Question 6

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) 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

Accepted Answer

If Morris invests half of his money in the sunglass company and half in the rain poncho company, he will earn $5,000 in a rainy year and $5,000 in a sunny year. Since there is a 50% chance of a rainy year and a 50% chance of a sunny year, his expected gain is $5,000 * 0.5 + $5,000 * 0.5 = $5,000.

Question 7

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

Accepted Answer

A positive correlation means that as one event increases, the other is likely to increase as well. In the case of a week-long power outage due to a large hurricane, the demand for batteries is likely to increase as people seek alternative power sources, indicating a positive correlation between these two events.

Question 8

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) 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

Accepted Answer

In a sunny year, Morris earns $5,000 from the sunglass company and loses $2,500 from the rain poncho company, netting $2,500. In a rainy year, he earns $5,000 from the rain poncho company and loses $2,500 from the sunglass company, also netting $2,500.

Question 9

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.

Accepted Answer

The insurance company does not need to assume that very few cars will be stolen; rather, it relies on statistical data and probability to estimate the number of thefts and set premiums accordingly.

Question 10

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 refers to the situation when sellers have more information about the quality of the product than the buyers and choose to sell inferior products to maximize their profit. This creates a problem because buyers may be unwilling to pay a higher price for a product of unknown quality, even if the seller has a high-quality product. As a result, the market may be dominated by low-quality products and overall gains from trade may be diminished.

Question 11

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) 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

Accepted Answer

Morris has a 50% chance of a sunny year and a 50% chance of a rainy year. If he invests all of his money in the rain poncho company, he will earn $10,000 in a rainy year and lose $5,000 in a sunny year. So, his expected gain or loss is (0.5 * $10,000) + (0.5 * -$5,000) = $2,500.

Question 12

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 facing financial trouble due to a wave of asbestos claims. The insurance company had underwritten policies during the 1970s and 1980s that covered companies against asbestos-related health claims, and the cumulative cost of these claims threatened to bankrupt the company.

Question 13

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

Accepted Answer

The practice of requiring a physical exam is a form of screening, which helps to reduce the problem of adverse selection. Adverse selection refers to the problem that arises when people who are higher risk are more likely to apply for insurance, which can lead to losses for the insurance company. By requiring a physical exam, the insurance company can better assess the person's health and therefore, the level of risk they pose.

Question 14

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

Accepted Answer

The answer of Which of the following is a limit...

Question 15

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

Accepted Answer

The spread of genetically modified crops and the presence of locusts are not directly correlated risks. Genetically modified crops are a technological advancement, while locusts are a natural pest issue, and they do not inherently influence each other.

Question 16

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 creates asymmetry in the market, which can distort economic decisions. It gives an unfair advantage to one party and may lead to adverse selection or moral hazard. Risk aversion (A) and blind trust (D) are not directly related to private information, and blind strategy (B) does not make sense in this context.

Question 17

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 occurs when one party has more information than the other and uses it to their advantage in a transaction. To deal with adverse selection, people can use screening, which involves gathering information about the other party to make a more informed decision. They can also use signals, which are actions or indicators that can provide information about the other party's quality. Reputation is another way to deal with adverse selection, as people are more likely to trust and do business with someone with a good reputation. Therefore, the best choice is D, which includes all three options.

Question 18

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.

Accepted Answer

Pooling involves spreading risk across many independent events, reducing the impact of any single event on the overall outcome.

Question 19

_____ 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

Accepted Answer

All the listed strategies (careful screening, examination of signals, and obtaining reference letters) are methods used to mitigate adverse selection in the labor market by gathering more information about the applicant's true abilities and characteristics.

Question 20

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 it allows insurance companies to spread risk over a larger population, which reduces their overall risk. This allows them to take on more risk and charge a lower premium than they would without pooling. The demand curve of insurance is not affected by pooling.

Quiz 20: Uncertainty, Risk, and Private Information

In which of the following situations is adverse selection most likely to be a problem?

Asymmetric, or private, information:

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

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?

If an insurance company insured 100,000 cars across the state against theft, which of the following would NOT be true?

The problem of adverse selection:

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

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

Investors in agricultural corporations face many correlated financial risks. Which of the following are NOT correlated risks for the agricultural industry?

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

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

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:

_____ is (are) a strategy(ies) for dealing with adverse selection in the labor market.

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.