Problem Set 9 Solutions

Problem Set 9 Solutions - for her to yield the same amount...

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Problem Set 9 Solutions Econ 115a Fall 2007 December 18, 2007 I. Problem 1 (a) Moral Hazard: the prospect that a party insulated from risk may behave differently than it would if it were fully exposed to the risk (b) An expected utility function assigns a benefit level to each possible state of nature based only on what is consumed, and then takes the expected value of those benefits. (c) Adverse Selection is a market process in which bad results occur due to information asymmetries between buyers and sellers: the "bad" products or customers are more likely to be selected. II. Problem 2 (a) Expected dollar value of the first lottery: EY1 = $4 Expected dollar value of the second lottery: EY2 = 1 * 1/2 + 9 * 1/2 = $5 (b) Misprint (c & d) EU1 = = 2, EU2 = * 1/2 + * 1/2 = 1/2 + 3/2 = 2 She is risk averse because it takes a higher expected dollar value in a higher risk situation
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Unformatted text preview: for her to yield the same amount of expected utility. (EU1=EU2 although EY1 < EY2) (e) She is indifferent because the expected utilities for both lotteries are the same. (EU1 = EU2) III. Problem 3 (a) p MU1 (1-p) MU2 (b) (c) Yes, the worker would want to buy unemployment insurance because the insurance would offset the loss of income from being laid-off and give the worker the same income in both situations if it was offered at a fair rate. (d) Moral hazard (For example, an individual with insurance against automobile theft may be less vigilant about locking his car, because the negative consequences of automobile theft are (partially) borne by the insurance company.) (e) Adverse selection (Government-provided unemployment insurance could prolong unemployment spells.) Y1= Y2 Y1 Y2 Y Expected Utility EY1 EY2 Y1* Y2* Y-L...
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