Suppose an insurance company determines that the average annual malpractice cost is $10,000 for reckless lawyers and $500 for careful lawyers. If 10% of the lawyers insured by the company are reckless, the company will earn zero economic profit if the price of insurance is
A) $500.
B) $1,450.
C) $5,250.
D) $10,000.

Question

Quizplus · Accepted Answer

If the price of insurance is $500, the company would earn zero profit because the cost of insuring careful lawyers would be covered by their premiums, and the profits from insuring reckless lawyers would offset the company's losses due to malpractice claims. However, if the price is above $500, the premiums from careful lawyers would cover the costs of their malpractice claims, but the profits from insuring reckless lawyers would not be sufficient to offset their losses due to malpractice claims. Therefore, the company requires a higher price to earn a profit. At $1,450, the expected profit from insuring reckless lawyers is 0.1x$10,000 = $1,000, and the profit from insuring careful lawyers is 0.9x$500 = $450, adding up to an average profit of $1,450 per lawyer.

Suppose an Insurance Company Determines That the Average Annual Malpractice