Question

1. An efficient market for risk, such as an insurance market, is MOST likely to exist:

Select one:

a. when there are significant differences between individuals' wealth levels and attitudes toward risk.

b. in the presence of private, or asymmetric, information.

c. when the sellers of insurance are risk-averse but the purchasers are not.

d. when there is a level playing field so that all participants have approximately the same wealth and the same degree of risk aversion.

2. Which pair of events is likely to be positively correlated?

Select one:

a. stock prices of computer companies and of tire companies

b. a week-long power outage due to a large hurricane and battery sales

c. hurricane damage in Florida and earthquake damage in California

d. sales of ice cream and cars on a hot summer day

3. Table: Choice with Uncertainty

Norman, a high school English teacher, is trying to decide whether to leave his job to work as a writer for a proposed television sitcom. His teaching job pays $40,000 per year and his is guaranteed 25,000 for the first year whether or not the sitcom makes it to television, 50,000 if it makes it to television but is not the most viewed show in its time slot and $100,000 if it makes it to television and is the most viewed show in its time slot. Norman wants to maximize his total utility and his utility function as shown in the table.

Income	Total Utility (utils)
$25,000	1,500
$30,000	1,900
$35,000	2,250
$40,000	2,550
$45,000	2,800
$50,000	3,000
$55,000	3,150
$60,000	3,250
$65,000	3,300
$100,000	3,500

Reference: Ref 20-9 Table: Choice with Uncertainty

(Table: Choice with Uncertainty) Use Table: Choice with Uncertainty. Suppose that the probability that the sitcom does not make it to television is 60%, that it makes it to television but is not the most viewed show in its time slot is 30%, and that it makes it to television and is the most viewed show in its time slot is 10%. As a utility maximizer, Norman:

Select one:

a. will be indifferent between leaving and staying because his expected income is the same whether he stays a teacher or moves to Hollywood.

b. should quit his teaching job and go to Hollywood.

c. will be indifferent between leaving and staying because his expected total utility is the same whether he stays a teacher or moves to Hollywood.

d. should keep his teaching job.

Answer 1

1) An efficient market for risk, such as insurance market, is most likely to exist when there are significant differences between individuals’ wealth levels and attitudes toward risk.

2) The pair of events which are likely to be correlated positively is a week long power outage due to a large hurricane and battery sales.

3) Expected Utility by leaving the job = 0.6*1500 + 0.3*3000 + 0.1*3500 = 2150 utils.

Expected utility by doing the job = 2550 utils.

So as a utility maximiser Norman should keep his teaching job because expected utility is higher in keeping the job.