Question

 

Part A) Both signaling and screening:

Multiple Choice

• reduce efficiency in the market.

• are effective ways to increase information available to both parties.

• benefit the sellers but harm the buyers.

• benefit the buyers but harm the sellers.

Part B) Rational people having preferences for immediate benefits and delayed costs is another way of saying that:

Multiple Choice

• money is worth less to us now than in the future.

• money is worth more to us now than in the future.

• the value of money does not change over time.

• rational people have insatiable wants.

Part C) The present value of $300,000 in 12 years at 4 percent interest is approximately:

Multiple Choice

• $312,451.

• $187,379.

• $427,126.

• None of these statements is true.

Part D) John is trying to decide whether to expand his business or not. If he continues his business as it is, with no expansion, there is a 50 percent chance he will earn $100,000 and a 50 percent chance he will earn $300,000. If he does expand, there is a 30 percent chance he will earn $100,000, a 30 percent chance he will earn $300,000 and a 40 percent chance he will earn $500,000. It will cost him $150,000 to expand. The expected value of John's earnings if he chooses to expand is:

Multiple Choice

• $320,000

• $230,000

• $900,000

• $140,000

Part E) When risks are shared across many different assets or people, reducing the impact of any particular risk on any one individual, it is called:

Multiple Choice

• diversification.

• indemnification.

• risk aversion.

• risk analysis.

Part F)

Because of the problem of adverse selection,

Multiple Choice

• low-risk individuals may have a hard time finding insurance worth buying.

• high-risk individuals may have a hard time finding insurance worth buying.

• everyone is typically charged a lower premium.

• individuals who buy insurance act more recklessly.

Answer 1

Part A) Both signalling and screening:

are effective ways to increase information available to both parties.

Reason: They help maximize information on the transaction to be done, in order to make an efficient decision

Part B) Rational people having preferences for immediate benefits and delayed costs is another way of saying that:

money is worth more to us now than in the future.

Reason: This is because the individual places more value on current benefits

Part C) The present value of $300,000 in 12 years at 4 percent interest is approximately:

$187,379

Reason: PV = 30000/(1.04)12 = 187,379

Part D) John is trying to decide whether to expand his business or not. If he continues his business as it is, with no expansion, there is a 50 percent chance he will earn $100,000 and a 50 percent chance he will earn $300,000. If he does expand, there is a 30 percent chance he will earn $100,000, a 30 percent chance he will earn $300,000 and a 40 percent chance he will earn $500,000. It will cost him $150,000 to expand. The expected value of John's earnings if he chooses to expand is:

$320,000

Reason: EV = 0.3(100,000) + 0.3(300,000) + 0.4(500,000) = 320,000

Part E) When risks are shared across many different assets or people, reducing the impact of any particular risk on any one individual, it is called:

Diversification

Reason: It refers to the act of diversifying risk across people or assets

Part F)

Because of the problem of adverse selection,

low-risk individuals may have a hard time finding insurance worth buying.

Reason: This is because insurance companies are unable to decide whether the individual is low risk or high risk