Microeconomics A Modern Approach 1st Edition Schotter Test Bank

Microeconomics A Modern Approach
1st Edition Schotter Test Bank

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Section 2. Preferences, Utilities, Demands, and Uncertainty 57
Chapter 7. Uncertainty--Applications and Criticisms
TRUE/FALSE
Exhibit 7-1
(a)
Utility of
Dollars
0
Dollars
(b)
Utility of
Dollars
0
Dollars
(c)
Utility of
Dollars
0
Dollars
1. Refer to Exhibit 7-1. Geoffrey is risk averse; therefore, his utility function most likely looks like Curve
(a).
ANS: F PTS: 1 DIF: Moderate NAT: Reflective Thinking

LOC: Utility and consumer choice TOP: The Creation of Insurance and Insurance Markets
58 Chapter 7. Uncertainty—Applications and Criticisms
2. Refer to Exhibit 7-1. Elizabeth is risk preferring; therefore, her utility function most likely looks like
Curve (c).
ANS: T PTS: 1 DIF: Moderate NAT: Reflective Thinking

3. Risk pooling or self-insurance is a method of avoiding risk whereby groups come together to form a
pool so as to share a risk if anyone in the group experiences a negative event.
ANS: T PTS: 1 DIF: Easy NAT: Analytic

LOC: Gains from trade, specialization and trade
TOP: Risk Pooling: The Growth of Insurance Companies
4. The proposition that states that, if a risk-averse agent is faced with two gambles, both of which have
the same expected monetary return but different variances, the agent will choose the gamble whose
variance is smaller is known as the mean-preserving spread proposition.

LOC: Understanding and applying economic models
5. Status quo bias is the term given to the fact that people have resistance to changing their current
situations even if the new one offered to them is better.

LOC: Utility and consumer choice TOP: Resolving Teaser 8
6. The Linda Problem demonstrates violations of the conjunction law.
ANS: T PTS: 1 DIF: Easy NAT: Reflective Thinking

TOP: Violation of Probability Rules
7. The Ellsberg Paradox illustrates ambiguity aversion.
ANS: T PTS: 1 DIF: Easy NAT: Reflective Thinking

8. People tend to think that low probability events are more likely than they are.

9. The reflection effect predicts that changing the sign on a set of choices will result in people’s changing
their preferences, even if the final outcomes and the probabilities attached to them are the same.

10. Because of the anomalies pointed out by Kahneman and Tversky, the expected utility theory is not a
useful tool to help us organize our thinking about economic decision making under conditions of
uncertainty.
ANS: F PTS: 1 DIF: Moderate NAT: Reflective Thinking

LOC: Utility and consumer choice TOP: Why Use the Expected Utility Theory?
MULTIPLE CHOICE
1. People are more likely to buy insurance if they are

a. risk averse
b. risk preferring
c. risk neutral
ANS: A PTS: 1 DIF: Easy NAT: Reflective Thinking
2. People are more likely to sell insurance if they are

a. risk averse
b. risk preferring
c. risk neutral
ANS: B PTS: 1 DIF: Easy NAT: Reflective Thinking
3. A risk-preferring person such as Elizabeth would be willing to sell insurance at a price

a. of zero
b. This question cannot be answered without knowing the exact shapes of the utility
functions
c. at which Elizabeth is indifferent between not insuring a Geoffrey and insuring him
ANS: C PTS: 1 DIF: Moderate NAT: Analytic
4. There ___________________ trading gains to be made in the sale of insurance policies.

a. randomly are or are not
b. are clearly
c. clearly are not
ANS: B PTS: 1 DIF: Easy NAT: Analytic
TOP: The Creation of Insurance and Insurance Markets
5. The profitability of insurance exists because

a. people have identical attitudes toward risk
b. big insurance companies always charge extremely high rates
c. people have different attitudes toward risk
ANS: C PTS: 1 DIF: Easy NAT: Analytic
6. A method of avoiding risk whereby groups come together to form a pool so as to share a risk if anyone
in the group experiences a negative event is known as
a. risk pooling
b. self-insurance
c. Both answers are correct
7. A decrease in variance makes a gamble _______ attractive.

a. less
b. equally
c. more
8. If a risk-averse agent is faced with two gambles, both of which have the same expected monetary
return but different variances, the agent will always choose the gamble whose variance is
a. greater
b. smaller
c. equivalent
9. Risk pooling can cut the variance of losses while keeping the mean intact. Hence, according to the
mean-preserving spread proposition, agents will be _____________ with risk pooling than without it.
a. worse off
b. better off
c. no better or worse off
10. As the population in the risk pool grows larger, the variance in the mean loss approaches
a. positive infinity
b. zero
c. negative infinity
11. Firms will continue to enter the insurance industry as long as

a. uncertainty exists
b. there are profits to be made in selling insurance
c. the population in the risk pool remains very small
ANS: B PTS: 1 DIF: Moderate NAT: Analytic
12. As a society’s agents face the uncertainties in their lives and try to come to terms with these
uncertainties,
a. insurance and an insurance industry will emerge
b. the agents will give up hope of success
c. gambling will strenghten as a social disease
ANS: A PTS: 1 DIF: Easy NAT: Analytic
13. In a survey of university hospital employees, when the insurance causes are broken down to individual
cases, people tend to overestimate the probability of each case happening. This is an example of
a. the effect of isolating vivid causes
b. status quo bias
c. the mean-preserving spread proposition
ANS: A PTS: 1 DIF: Moderate NAT: Analytic
LOC: Understanding and applying economic models TOP: Resolving Teaser 8
14. Expected utility theory requires that people

a. assess probabilities in an unbiased manner
b. obey all of the theory’s axioms for assigning utilities to outcomes
c. Both answers are correct
LOC: Utility and consumer choice TOP: How Could Expected Utility Be Wrong?
15. The Linda Problem is an example of

a. violations of the conjunction law
b. ambiguity aversion
c. violation of base rates
ANS: A PTS: 1 DIF: Easy NAT: Reflective Thinking
16. The Ellsberg Paradox is an example of

a. violations of the conjunction law
b. ambiguity aversion
c. violation of base rates
ANS: B PTS: 1 DIF: Easy NAT: Reflective Thinking
17. Tina Sierra investigated a fight outside a college classroom. At this college, 75 percent of the students
are female and 25 percent are male. Bob, a witness, testified that a male started the fight. After testing,
Tina determined that Bob correctly identifies a person’s gender 90 percent of the time. Tina concluded
that there was a 90 percent chance that a male started the fight. Her mistake is a(n)
a. use of nonlinear probability weights
b. violation of base rates
c. framing error
ANS: B PTS: 1 DIF: Hard NAT: Reflective Thinking
18. People tend to

a. make a distinction between events that are certain and those that are close to, but are not
certain
b. think that low probability events are less likely than they are
c. overplay or overweigh events that are close to, but are not certain
19. When people use ____________ probability weights, people assign too _________ weight to very low
probabilities and too _________ to high probabilities.
a. nonlinear, little, much
b. nonlinear, much, little
c. linear, much, little
20. This is gamble 1: do you prefer a sure win of $5 or a 75% chance to win $8? This is gamble 2: in the
first stage, you have an 80% chance to end the game with no prize and a 20% chance to move to the
second stage. Before completing the first stage, you must select one of the following second-stage
choices: do you prefer a sure win of $5 or a 75% chance to win $8? This is gamble 3: do you prefer a
20% chance to win $5 or a 15% chance to win $8? Which two of the preceding gambles are identical?
a. gamble 1 and 2
b. gamble 2 and 3
c. gamble 1 and 3
ANS: B PTS: 1 DIF: Hard NAT: Reflective Thinking
LOC: Utility and consumer choice TOP: Violation of Probability Rules
21. This is gamble 1: do you prefer a sure win of $5 or a 75% chance to win $8? This is gamble 2: in the
first stage, you have an 80% chance to end the game with no prize and a 20% chance to move to the
second stage. Before completing the first stage, you must select one of the following second-stage
choices: do you prefer a sure win of $5 or a 75% chance to win $8? This is gamble 3: do you prefer a
20% chance to win $5 or a 15% chance to win $8? Because of framing, which two of the gambles do
people tend to treat incorrectly as identical?
a. gamble 1 and 2
b. gamble 2 and 3
c. gamble 1 and 3
ANS: A PTS: 1 DIF: Hard NAT: Reflective Thinking
22. Kahneman and Tversky concluded that people

a. maximize their expected utility by multiplying it by probabilities
b. use probability weights in place of raw probabilities
c. process probabilities in an unbiased and unemotional manner
ANS: B PTS: 1 DIF: Moderate NAT: Analytic
LOC: Utility and consumer choice TOP: Resolving Teaser 9
23. Kahneman and Tversky suggest that the way people go about assigning values to utilities of prizes is
by
a. defiining for themselves a status quo outcome only
b. judging all outcomes other than the status quo as either gains or losses from the status quo
only
c. defiining for themselves a status quo outcome and judging all outcomes other than the
status quo as either gains or losses from the status quo
24. While the marginal utility of increments from the status quo is considered to be _____________, the
marginal utility of decrements below the status quo is _____________.
a. decreasing, increasing
b. increasing, decreasing
c. decreasing, constant
25. Researchers who study the application of neuroscience to economics are known as
a. brain surgeons
b. mad monkey doctors
c. neuroeconomists
SHORT ANSWER
1. Describe the trading gains to be made in the sale of insurance policies.
ANS:
A risk-averse buyer of insurance gains protection from losses. At price lower than the expected loss,
the buyer will willingly purchase an insurance policy. At a high enough price, the seller of insurance
can earn a profit, even given the probability of paying a benefit on the insurance policy.
PTS: 1 DIF: Moderate NAT: Analytic

TOP: The Creation of Insurance and Insurance Markets
2. Explain how a risk-averse buyer of insurance obeys the mean-preserving spread proposition.
ANS:
The proposition states that, if a risk-averse agent is faced with two gambles, both of which have the
same expected monetary return but different variances, the agent will always choose the gamble whose
variance is smaller. The gamble with the smaller variance will have a greater expected utility and the
agent will therefore want to pay less to insure against that gamble.
PTS: 1 DIF: Hard NAT: Analytic

3. What is Linda’s problem?
ANS:
According to the laws of probability, it can never be more likely that Linda is both a bank teller and a
feminist than either of these alone. Yet 90% of subjects asked said that is was more likely that Linda is
both a bank teller and a feminist than either of these alone. The description of what Linda is like made
it seem that, whatever she did, she would be a feminist, so being a bank teller and a feminist struck the
subjects as more likely certainly than being a bank teller alone. Subjects made their judgment of Linda
without correctly applying the laws of probability.

4. Describe the difference between linear and nonlinear probability weights.
ANS:
A linear probability weight is the raw probability itself. But people may have a hard time evaluating
and differentiating between low and high probabilities and may attach importance to these
probabilities that are not equal to the probabilities themselves. These latter distortions are nonlinear
probability weights.

5. Why use the expected utility theory?
ANS:
Despite the anomalies pointed out by Kahneman and Tversky, the expected utility theory is still a very
useful tool because it helps us organize our thinking about economic decision making under conditions
of uncertainty. Even flawed theories can offer benefits as long as we are aware of their limitations.
PTS: 1 DIF: Easy NAT: Analytic LOC: Utility and consumer choice
TOP: Why Use the Expected Utility Theory?

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Microeconomics A Modern Approach

1st Edition Schotter Test Bank

Chapter 7. Uncertainty--Applications and Criticisms

ANS: F PTS: 1 DIF: Moderate NAT: Reflective Thinking

ANS: T PTS: 1 DIF: Moderate NAT: Reflective Thinking

ANS: T PTS: 1 DIF: Easy NAT: Analytic

ANS: T PTS: 1 DIF: Easy NAT: Analytic

ANS: T PTS: 1 DIF: Easy NAT: Analytic

6. The Linda Problem demonstrates violations of the conjunction law.

ANS: T PTS: 1 DIF: Easy NAT: Reflective Thinking

7. The Ellsberg Paradox illustrates ambiguity aversion.

ANS: T PTS: 1 DIF: Easy NAT: Reflective Thinking

ANS: T PTS: 1 DIF: Easy NAT: Analytic

ANS: T PTS: 1 DIF: Easy NAT: Analytic

ANS: F PTS: 1 DIF: Moderate NAT: Reflective Thinking

1. People are more likely to buy insurance if they are

2. People are more likely to sell insurance if they are

3. A risk-preferring person such as Elizabeth would be willing to sell insurance at a price

4. There ___________________ trading gains to be made in the sale of insurance policies.

5. The profitability of insurance exists because

7. A decrease in variance makes a gamble _______ attractive.

11. Firms will continue to enter the insurance industry as long as

14. Expected utility theory requires that people

15. The Linda Problem is an example of

16. The Ellsberg Paradox is an example of

18. People tend to

22. Kahneman and Tversky concluded that people

1. Describe the trading gains to be made in the sale of insurance policies.

PTS: 1 DIF: Moderate NAT: Analytic

PTS: 1 DIF: Hard NAT: Analytic

3. What is Linda’s problem?

PTS: 1 DIF: Moderate NAT: Analytic

4. Describe the difference between linear and nonlinear probability weights.

PTS: 1 DIF: Moderate NAT: Analytic

5. Why use the expected utility theory?

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