Question 1

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

Accepted Answer

Studies have actually shown that the poor are more risk-averse than the wealthy. This may be due to the fact that the poor have less ability to withstand loss, while the wealthy have more resources to fall back on in case of a loss.

Question 2

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 3

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 4

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 5

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

Accepted Answer

The statement is incorrect. Two events can be independent even if they happen at the same time and place, as long as they are not related or influenced by each other.

Question 6

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 7

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 8

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 allow individuals to transfer or mitigate certain risks, reducing their overall exposure to potential losses.

Question 9

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

A risk-averse expected-utility maximizer will only take a bet if the expected payoff is positive. In this case, the expected payoff is zero since the probability of winning and losing is the same and the amounts gained and lost are equal. Therefore, Jill will not take the bet.

Question 10

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

Accepted Answer

Risk-averse individuals may not purchase insurance if the premiums charged are too high. The decision to purchase insurance depends on the cost-benefit analysis of the premiums charged versus the perceived risk of loss.

Question 11

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 is true. These are all common strategies used to address adverse selection.

Question 12

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

Accepted Answer

Buying a warranty is a form of insurance that can protect the buyer from the risks associated with a faulty or malfunctioning product. By paying for the warranty, the buyer is avoiding the potential financial loss of having to replace or repair the TV out of pocket. Therefore, this is an example of paying to avoid risk.

Question 13

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

Accepted Answer

Risk-averse individuals prioritize risk reduction over maximizing their income, so they may accept lower paying deals in exchange for reduced risk.

Question 14

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 their medical expenses without insurance is (0.3 x $0) + (0.7 x $8,000) = $5,600
With the insurance, they pay a premium of $6,000 and are guaranteed to have their medical expenses covered, regardless of the state. Therefore, they are essentially paying $6,000 to avoid the potential loss of $8,000 in state 2. This means they are worse off with the insurance policy, as they are paying more than the expected loss they would incur without insurance. Thus, it is not a fair insurance policy from the Bakers' point of view.

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

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

Accepted Answer

Adverse selection and moral hazard both create market inefficiencies by altering the behavior of buyers and sellers. Adverse selection occurs when a buyer or seller has access to asymmetric information and acts in a way that negatively impacts the other party. Moral hazard occurs when one party engages in risky behavior because they know that they are protected from the consequences. Both of these phenomena can lead to inefficient outcomes as they distort market signals and prevent mutually beneficial transactions from taking place.

Question 17

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

Accepted Answer

A fair insurance policy ensures that the premium paid by the policyholder is equal to the expected value of the claim, meaning that the policyholder pays an amount proportional to the risk they represent to the insurance company. This way, the insurance company can cover the cost of the claims while providing a fair and reasonable premium to policyholders.

Question 18

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

Accepted Answer

Moral hazard can occur even when people are acting in their best interest, but take risks that are borne by others. This can happen when individuals or organizations have incomplete information, asymmetric information, or limited liability.

Question 19

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 the most willing to bear risk are likely to be compensated in some way for doing so, such as through higher returns on their investments or insurance premiums. Meanwhile, those who are less willing to bear risk may be willing to pay a premium to transfer that risk to someone else who is better equipped to handle it. By matching up these two groups, an efficient allocation of risk can be achieved.

Question 20

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

Accepted Answer

When private information exists, individuals may not have access to all the necessary information to make an informed decision about a transaction. This can result in both parties being worse off or missing out on potential mutually beneficial transactions. This information asymmetry can lead to economic inefficiencies.

Quiz 19: Uncertainty, Risk, and Private Information