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Lec_16_financial_crisis

# Lec_16_financial_crisis - Chapter 12 Economics of...

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1 • Second exam will cover only Chapters 10- 12 • Final exam will be cumulative for entire course • Answers to practice second exam will be reviewed in discussion sections week of Fri Nov 4 to Wed Nov 9 • An alternative practice exam is also available on the course web page Chapter 12: Economics of Information F. Resolving asymmetric information with costly-to-fake signaling G. 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, …) • 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 • People buy policy because they are risk averse • Insurance company makes profit from law of large numbers • Note: for some kinds of insurance (e.g., earthquake) law of large numbers doesn’t apply-- just roll dice once Potential problems with insurance markets: (1) Adverse selection

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2 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 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 must charge more than \$550 premium to make a profit 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 consumers’ risk aversion is such that they’re willing to pay \$1.00 premium for every 50¢ in expected payout 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
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Lec_16_financial_crisis - Chapter 12 Economics of...

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