Lecture 24

# Lecture 24 - Final exam Wed March 19 8:00 a.m 30 Chapters 5...

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1 Final exam: Wed March 19, 8:00 a.m. 30%: Chapters 5, 12-16 70%: Chapters 17-20 Chapter 19: Uncertainty and information A. Risk and expected value B. Risk neutrality and risk aversion C. Private information D. Insurance markets Insurance policy: • I pay the insurance company some money now (called the insurance premium) • The insurance company will cover my expenses if a certain event occurs (house burns down, car is in accident, I get cancer, …)

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2 • Insurance premium is more than the expected value of payout • E.g., I pay \$500 for a car insurance policy that has 1/100 chance of paying \$20,000 • insurance premium = \$500 • expected payout = \$200 • Insurance company makes profit from law of large numbers • People buy policy because they are risk averse Potential problems with insurance markets: (1) Adverse selection Suppose there are two kinds of drivers: • safe drivers: probability of accident = 1/200 per year • risky drivers: probability of accident = 1/20 per year • payout for accident = \$20,000
3 Expected payout for safe drivers: (1/200) x (\$20,000) = \$100 per year Expected payout for risky drivers: (1/20) x (\$20,000) = \$1,000 per year Suppose that ½ the drivers are safe and ½ are risky and an insurance company issues same policy to both types Expected payout for safe drivers: (1/200) x (\$20,000) = \$100 per year Expected payout for risky drivers: (1/20) x (\$20,000) = \$1,000 per year Insurance company’s expected payout is: (1/2) x (\$100) + (1/2) x (\$1,000) = \$550 per policy Insurance company could charge \$550 per policy and still

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Lecture 24 - Final exam Wed March 19 8:00 a.m 30 Chapters 5...

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