20-2 Business Loan
A colleague tells you that he can get a business loan from the bank, but the rates seem very high for
what your colleague considers a low risk loan.
Give an adverse selection explanation for this, and offer advice to your friend on how to
solve the problem.
Give a moral hazard explanation for this, and offer advice to your friend on how to solve
20-3 Locator Beacons for Lost Hikers
Lightweight personal locator beacons are now available to hikers that make it easier for the Forest
s rescue teams to locate those lost or in trouble in the wilderness. How will this affect the
costs that the Forest Service incurs?
20-4 Auto Insurance
Suppose that every driver faces a 1% probability of an automobile accident every year. An accident
will, on average, cost each driver $10,000. Suppose there are two types of individuals:
$60,000 in the bank and those with $5,000 in the bank. Assume that individuals with $5,000 in the
bank declarebankruptcy if they get in an accident. In bankruptcy,creditors receive only what
individualshave in the bank. What is the actuarially fairprice of insurance? What price are
individualswith $5,000 in the bank willing to pay for theinsurance? Will those with $5,000 in the
bankvoluntarily purchase insurance? What is the effectof state laws forcing individuals to
purchaseauto liability insurance?