Q: If the fair price of insurance for a $$20,000 motor home with a 0.02% chance of total loss (and 3$$,000 salvage value) is calculated, what is the correct formula?

$$0.0002 \times (20,000 - 3,000)$$

Question 1

Which of the following best describes a risk-averse individual’s utility function, as illustrated in the provided diagram?

Accepted Answer

It is concave with respect to income, indicating diminishing marginal utility.

Question 2

Suppose Lisa faces a 60% chance of earning $$100,000 and a 40% chance of losing 20$$,000 from her vineyard. What is the expected value (EV) of her income?

Accepted Answer

$52,000

Question 3

Given Lisa’s risk aversion and the offer of a guaranteed $70,000 for her harvest, what should she do?

Accepted Answer

Accept the offer because the guaranteed amount is higher than the expected value of her risky income.

Question 4

What is the formula for expected utility (EU) when facing two possible outcomes with probabilities $$p$$ and $$1-p$$ and utilities $$U_1$$ and $$U_2$$?

Accepted Answer

$$EU = pU_1$ + (1-p)U_2$

Question 5

A risk-neutral person is offered a gamble with a 0.001 probability of winning $$500 and a 0.999 probability of winning nothing for a 1 $$ticket. Should they buy the ticket?

Accepted Answer

No, because the expected value is less than the ticket price.

Question 6

Why might an insurance company behave as if it were risk neutral, even if its managers are risk averse?

Accepted Answer

Because the company can diversify risk across many policies, reducing overall risk.

Question 7

If the fair price of insurance for a $$20,000 motor home with a 0.02% chance of total loss (and 3$$,000 salvage value) is calculated, what is the correct formula?

Accepted Answer

$$0.0002 	imes (20,000 - 3,000)$$

Question 8

Why do risk-averse individuals often pay more than the expected value of a loss for insurance?

Accepted Answer

Because the pain of a large loss is disproportionately greater than the pain of paying a premium.

Question 9

Suppose Natasha’s utility function is $$u(I) = (10I$$)^{1/2}$$, where I$ is income in thousands. If she is offered a gamble with a 0.5 probability of gaining 1$$,000$$ and a 0.5 probability of losing 1$$,000$$ from a base of 10$$,000$$, what is her expected utility from the gamble?

Accepted Answer

$$9.987$$

Question 10

What is the risk premium in the context of Natasha’s job offer, where her expected income is $$39,600$$ and the certainty equivalent is $$39,402$$?

Accepted Answer

$$198$$

Question 11

Which of the following best explains the endowment effect, as illustrated by Jennifer’s shirt-buying behavior?

Accepted Answer

People value goods more once they own them than before they own them.

Question 12

If a corporation faces a $$5,000,000$$ loss if both executives die in a crash, and the probability of a crash is $$0.000000432$$, what is the expected loss from flying together?

Accepted Answer

$$2.16$$

Question 13

Why do most investment counselors recommend that clients shift their portfolios toward bonds as they age?

Accepted Answer

Older clients are more risk averse and have less time to recover from losses.

Question 14

What is adverse selection in the context of insurance markets?

Accepted Answer

When high-risk individuals are more likely to purchase insurance, raising costs for everyone.

Question 15

Which of the following is a reason why employers do not eliminate all risk from jobs?

Accepted Answer

It may be cheaper to pay a wage premium for risky jobs than to eliminate all risk.

Question 16

If the probability of good weather is overestimated by a buyer like Ethan, what is a likely consequence?

Accepted Answer

He may offer to buy the harvest at a price higher than the expected value.

Question 17

In the context of behavioral economics, what does the reference point effect imply?

Accepted Answer

People’s choices depend on their current situation or ownership status.

Question 18

When is it worth paying for additional information to reduce uncertainty?

Accepted Answer

When the expected utility with information, minus the cost, exceeds the expected utility without information.

Question 19

If Sam’s risky project has an expected return of $$1,000$$ and he is risk neutral, what is the maximum he would pay for insurance to guarantee this return?

Accepted Answer

$$0$$

Question 20

If new information reveals that a competitor will soon enter the market, how should an insurance agent adjust the premium for insuring Sam’s project?

Accepted Answer

Raise the premium, because the probability of a high payoff has decreased.

Uncertainty and Risk in Microeconomics

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