Question

QUESTION 1

1. For an auto insurance company, the average cost of collision claims is $500 per year for careful drivers and $3000 per year for poor drivers. The drivers are risk neutral and know whether they are careful or poor, but the insurance company only knows that 15% of drivers are poor. What is the insurance company's breakeven price for the collision insurance?

   	A.	$425 per year
   	B.	$450 per year
   	C.	$875 per year
   	D.	$2,625 per year

2 points   

QUESTION 2

1. An engineering consulting firm finds two types of employees in the labor pool.  Some workers with adequate skills generate annual returns equal to $120,000, and highly skilled employees generate annual returns equal to $200,000.  The workers know if they are adequate or highly skilled, and they reject salaries below their value to the firm. Overall, 10% of the workers are highly skilled.  If the consulting firm pays everyone a salary equal to the expected returns, what is the firm's profit per worker?

   	A.	-$8,000
   	B.	-$800
   	C.	$0
   	D.	$8,000

2 points   

QUESTION 3

1. Which parties should use signaling techniques to resolve problems associated with adverse selection?

   	A.	Neither party should use signaling to resolve adverse selection problems
   	B.	Both parties should use signaling
   	C.	Less informed parties
   	D.	More informed parties

2 points   

QUESTION 4

1. Which of the following actions is an example of signaling?

   	A.	A brake pad manufacturer offers a lifetime warranty
   	B.	A lawyer offers to to paid only if they win the case for their client
   	C.	A student pursues a graduate degree
   	D.	All of the above

2 points   

QUESTION 5

1. The demand for insurance arises mainly from people who are:

   	A.	Risk averse
   	B.	Risk loving
   	C.	Risk neutral
   	D.	None of the above

Answer 1

1. The correct option is C- 875 dollar per year

The insurance company does not have complete information and cannot distinguish between the poor and careful drivers. Thus, it would charge an collision insurance equal to 0.15*3000 + 0.85*500 = 875

2. Expected returns equal to probability of high skilled labor * returns of high skilled labor + probability of adequate skilled labors* returns of adequate skilled labors = 0.10*200, 000+ 0.90*120,000 = 128,000

If firms pays expected salary equal to expected returns, both will be 128,000. Thus profit per worker would be zero. Thus option C is correct. For high skilled worker, the firm will make profit of 200,000- 128,000 = 72,000 and for adequate skilled workers it would make loss of 8,000. On average the profit and losses would cancel out.

3. More informed parties should use signaling to communicate information to the less informed parties. Thus, correct option is D. If all parties would use signaling, the purpose of signaling would fail.

4. All the three options given are examples of signalling. Providing a lifetime warranty, the manufacturer signals that he has produced a good quality product to the consumer. The lawyer signals that he would definitely win the case and thus, high abilities must be trusted by the client. This is also an example of signalling. The student uses educational signalling through his graduation degree. He signals that he posses skills required for the job.

Thus, correct option is D

5. The demand for insurance mainly arises from the risk averse person because they want to minimise their risks and thus opts for insurance schemes. Thus, correct option is A.