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SOLUTIONS FOR TERM TEST #2

Professor H. Krashinsky

Multiple Choice:

1. T 4. I 6. T 9. M 11. K 14. Z 17. W 19. I


2. N 5. H 7. O 10. B 12. C 15. F 18. J 20. D
3. K 8. S 13. L 16. N

Short Answer:

2.(a) A.F. priced insurance = (1/500)($875,000) + (1-(1/500))($0) = $1,750


EU(not buying ins.) = (1/500)(40(125,000)1/3) + (499/500)(40(1,000,000)1/3) = 3,996
U(buying ins.) = U(I = $1,000,000 – $1,750) = 40(998,250)1/3 = 3,997.67
Since U(buying ins.) > EU(not buying ins.), the consumer will buy insurance

(b) Let I* = 1,000,000 – M, where M = maximum amount consumer will pay for ins.
U(I*) = EU(not buying ins.)
40(I*)1/3 = 3,996 Æ (I*)1/3 = 99.9 Æ I* = 997,003
Therefore, M = 1,000,000 – I* = 1,000,000 – 997,003 = $2,997

(c) A.F. Intermediate price = (0.5)[(1/500)($875,000) + (1-(1/500))($0)]


+ (0.5)[(1/100)($875,000) + (1-(1/100))($0)] = $5,250
This is greater than the maximum price that the low-risk will pay, so low-risk won’t buy
A.F. final price = (1/100)($875,000) + (1-(1/100))($0) = $8,750
High-risk will buy this policy because U(buying ins) = 40(991,250)1/3 = 3,988.30
EU(not buying ins.) = (1/100)(40(125,000)1/3) + (99/100)(40(1,000,000)1/3) = 3,980

(d) Let q = probability of an accident for high-risk consumers. Thus:


A.F. Intermediate price = (0.5)[(1/500)($875,000) + (1-(1/500))($0)]
+ (0.5)[(q)($875,000) + (1-q)($0)] = 875 + 437,500q
In this case, U(buying insurance) = 40*[1,000,000 – (875 + 437,500q)]1/3
= 40*[999,125 – 437,500q]1/3
The value of q is found by setting: U(buying insurance) = EU(not buying ins.)
Æ 40*[999,125 – 437,500q]1/3 = 3,996
divide both sides by 40 Æ [999,125 – 437,500q]1/3 = 99.9
cube both sides Æ 999,125 – 437,500q = 997003
Æ 437,500q = 2,122 Æ q = 2,122/437,500 = 0.00485

3.(a) E(profits, no information, no irrigation) = (0.75)($4,800) + (0.25)($1,600) = $4,000


E(profits, no information, irrigation) = $4,800 – $1,200 = $3,600
E(profits, perfect information) = (0.75)($4,800) + (0.25)($3,600) = $4,500
Max payment = E(profits, perfect information) – best alternative = $4,500 – $4,000 = $500

(b) E(profits, imperfect information) = (0.65)($4,800) + (0.1)($1,600)


+ (0.15)($3,600) + (0.1)($3,600) = $4,180
Max payment = E(profits, imperfect information) – best alternative = $4,180 – $4,000 = $180