Pepperdine University

FINC 655

Chapter 19

Multiple Choice Questions

1)An insurance company offers doctors malpractice insurance. Assume that malpractice claims against careful doctors cost $5,000 on average over the term of the policy and settling malpractice claims against reckless doctors costs $30,000. Doctors are risk-neutral and know whether they are reckless or careful, but the insurance company only knows that 10% of doctors are reckless. How much do insurance companies have to charge for malpractice insurance to break even?

1. 1. $5,000 [both reckless and careful doctors would purchase insurance at this price.]
   2. $7,500 [because careful doctors are risk-neutral, they would not purchase insurance at this price, leaving the insurance company only with reckless doctors.]
   3. $27,500 [the insurance company would insure only reckless doctors, losing $2,500 on each insured.]
   4. $30,000 [only reckless doctors would purchase insurance at this price.]

2. An employer faces two types of employees. Regular workers are 70% of the population and generate $100,000 in productivity. Exceptional workers are 30% of the population, and generate $120,000 in productivity. Employees know their types, and reject salaries below their productivity. If the employer offers a salary equal to the average productivity in the population, what will be the employer’s per-employee profit?

a. -$10,000 [the average productivity is $100,000(70%)+$120,000(30%)=$106,000

2. -$6,000 [the employer would offer $106,000 but hire only regular workers generating $100,000 in productivity.]
3. $0 [this answer ignores the adverse selection problem.]
4. $4,000 [adverse selection implies that profits would be negative, not positive]

3. An all-you-can-eat buffet attracts two types of customers. Regular customers value the buffet at $20 and eat $5 of food in costs to the restaurant. Hungry customers value the buffet at $40 and eat $10 of food. If there are 100 of each type in the market for a buffet dinner, what is the restaurant’s maximum profit?
   1. $2,500 [this is obtained by charging $20, but the restaurant can do better.]
   2. $3,000 [by charging $40, the restaurant attracts only hungry customers.]
   3. $4,500 [this level of profit is unobtainable as the restaurant can attract at most 100 customers at $40 or 200 customers at $20.]
   4. $6,500 [this level of profit is unobtainable and exceeds the total value of all customers.]

4. To combat the problem of adverse selection,    informed parties can employ      techniques.
   1. more; signaling [signaling is a more informed party’s effort to communicate her information to the less informed party]
   2. less; signaling [the less-informed party’s effort to learn the information that the more informed party has is called screening.]

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1. 3. equally; screening [adverse selection arises because parties are not equally informed]
   4. equally; signaling [adverse selection arises because parties are not equally informed]

5. Which of the following can be an example of a signal?
   1. An air-conditioning manufacturer offers a 50-year warranty. [this signals quality as the warranty is more expensive to honor for an inferior product; this is not the only correct answer]
   2. A lawyer offers to be paid only if the client wins. [this signals a higher likelihood of winning as the contingent fee is less a risk if the chance of winning is high; this is not the only correct answer
   3. A student pursues an MBA. [this can signal dedication, willingness to work hard, or other traits.]
   4. All of the above [all of the above are possible signals]

6. Which of the following is not an example of adverse selection?
   1. A business bets the proceeds of a bank loan on the next NFL game. [this is an example of moral hazard rather than adverse selection.]
   2. An accident-prone driver buys auto insurance. [this is adverse selection as drivers who are more expensive to insure are more likely to buy insurance.]
   3. A patient suffering from a terminal disease buys life insurance. [this is adverse selection as patients who are more expensive to insure are more likely to buy insurance.]
   4. A really hungry person decides to go to the all-you-can-eat buffet for dinner. [this is adverse selection as customers who are more expensive to serve are more likely to buy the buffet.]

7. The demand for insurance arises primarily from people who are
   1. risk-seeking. [risk-seeking individuals are less willing to pay a premium in order to eliminate a risk.]
   2. risk-averse. [risk-averse individuals are willing to pay more to avoid risks and thus are most likely to purchase insurance.]
   3. risk-neutral. [risk-neutral individuals are willing to insure only when the premium costs less than the expected loss.]
   4. None of the above [willingness to pay for insurance depends on one’s risk tolerance.]

8. Which of the following is a potential solution to the adverse selection problem faced by insurance companies?
   1. Offer plans with different deductibles so that higher-risk customers accept higher deductibles. [the deductible is a signal that reveals each insured’s risk, reducing adverse selection; this is not the only correct answer.]
   2. Create a national database of customers that allows companies to look up each person’s historical risk. [this provides information about each insured’s risk, reducing information asymmetry.]
   3. Mandate that every person purchase insurance. [this eliminates adverse selection by prohibiting low-risk individuals from exiting the insurance market.]

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