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 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 2

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 cases where some individuals in an economic transaction have information that others do not. This can lead to inefficiencies in markets and a lack of trust between parties. It is common in situations like buying a used car, where the seller may have more information about the car's condition than the buyer, or in the case of medical treatment, where the doctor may have more information than the patient. Asymmetric information can lead to problems like adverse selection, moral hazard, and principal-agent problems.

Question 3

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 cannot assume that very few cars will be stolen as theft is always a possibility. However, they can use historical data and statistical analysis to make an educated guess on the number of thefts and the expected payoff on the policies.

Question 4

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 occurs when one party in a transaction has more information than the other party and uses it to their advantage. In the case of adverse selection in markets, sellers who know more about the quality of their products may deliberately select inferior products to sell to unsuspecting buyers. This can lead to a decrease in overall gains from trade as buyers may be hesitant to purchase goods due to the risk of receiving a low-quality product.

Question 5

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

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

Question 6

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 known only to a particular person or group and is not generally available. When this occurs, it can distort economic decisions because the other parties don't have access to this information and may make decisions based on incomplete or faulty information.

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) 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 is designed to lessen the problem of adverse selection. Adverse selection occurs when individuals with a higher risk of illness or mortality are more likely to purchase insurance, which can lead to increased costs for the insurance company. By screening applicants and gathering information about their health, the insurance company can better assess the risk of insuring that individual and adjust premiums accordingly.

Question 8

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

Accepted Answer

If relevant events are positively correlated (meaning they tend to move in the same direction), diversification will not reduce risk because all investments will be affected similarly. For example, if an investor has a portfolio consisting solely of technology stocks, diversifying by adding more technology stocks will not reduce risk because they are all likely to be affected by the same industry-specific factors. However, if they added stocks from different industries such as healthcare and consumer goods, they may see a reduction in risk as factors affecting one industry may not necessarily affect the other.

Question 9

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 in a transaction has more information than the other party, causing the uninformed party to make a decision that is not in their best interest. Screening is a tool used by the uninformed party to gather more information about the other party and reduce adverse selection. Signals are also used by the informed party to convey information about their quality to the uninformed party and reduce adverse selection. Reputation is built over time through consistent behavior and can be used by either party to reduce adverse selection. Therefore, the best choice is D as all three options, screening, signals, and reputation, are commonly used to deal with adverse selection.

Question 10

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 11

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 multiple assets to reduce the risk of losses. By investing in different assets, any possible losses incurred in one asset will have little or no impact on the returns from the other assets. This reduces the overall volatility of the portfolio and increases the chances of achieving the desired returns. Private information, moral hazard, and adverse selection are all concepts related to asymmetric information and are not related to diversification.

Question 12

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 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) 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 each company, then he would expect to earn $5,000 in a rainy year from the rain poncho company and lose $2,500 from the sunglass company. In a sunny year, he would expect to earn $5,000 from the sunglass company and lose $2,500 from the rain poncho company. His overall expected gain would be $2,500. Therefore, investing in both companies is the best choice for Morris as it reduces his risk and maximizes his expected gain.

Question 14

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 allows insurance companies to spread risk across a larger group, enabling them to take on more risk at a lower premium, which increases the supply of insurance.

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 correlated risks for the agricultural industry. The spread of genetically modified crops may have regulatory and public perception risks, but it does not generally affect agricultural company financials. The presence of locusts is a pest control issue that primarily affects individual crops and farmers, rather than the overall industry.

Question 16

_____ 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

Adverse selection refers to the situation where one party in a transaction has more information than the other, leading to an imbalance of information. In the labor market, adverse selection can occur if job applicants provide false or incomplete information about their skills or work history, which can lead to poor hiring decisions. To deal with this problem, employers may use a combination of careful screening, examination of signals from an applicant (such as education, experience, or certifications), and obtaining reference letters from an applicant's previous place of employment. Therefore, the best choice is D.

Question 17

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

If Morris invests all his money in the sunglass company, he will have a 50% chance of gaining $10,000 and a 50% chance of losing $5,000, resulting in an expected gain of $2,500 [(0.5 x $10,000) + (0.5 x (-$5,000)) = $2,500]. Therefore, he should choose to invest all his money in the sunglass company. However, diversification would be the safer choice as it spreads the risk and reduces the potential losses.

Question 18

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

Accepted Answer

The term "pooling" refers to the act of taking a small share in many independent events or taking advantage of predictability associated with large numbers of independent events in order to almost eliminate risk. Therefore, the best choice is C.

Question 20

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 faced financial trouble due to a large number of asbestos-related claims in the late 1980s, which created a significant liability for the organization. The other options mentioned (major recession, terror attacks, war in Iraq) did not play a substantial role in Lloyd's financial troubles during this period.

Quiz 19: Uncertainty, Risk, and Private Information

Asymmetric, or private, information:

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:

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

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 _.

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

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

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

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

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

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.

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

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

Which pair of events is likely to be positively correlated?

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:

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