CORRECT WELL DETAILED ANSWERS|LATEST
UPDATE!!!!!!2025/2026|GUARANTEED
ANSWER Chapter 7
- risk because there is a fear of the unknown
- forfeiting income in good times to get money in bad times - ANSWER Demand for
Insurance
U'(1)>0, utility increases with income
U''(1)<0, marginal utility for income is declining - ANSWER Risk Aversion
- probability of sickness= P (between 0 and 1)
- probability healthy= 1-p
- Is= income if sick
- IH>Is= income if healthy
E(I)= PIs + (1-P)U(IH) - ANSWER Uncertainty
- P=1
- E(U)= U(Is)= Is
- P=0
- E(U)=U(IH)= IH
SEE GRAPH - ANSWER Probability of Sickness
- customer pays up front fee
1
,- r= insurance premium
- if ill customer gets q- insurance pay out
- sick: IH+q-r
- healthy: Is+0-r
- optimal: Is'=IH', full insurance with no uncertainty - ANSWER Health Insurance
Contract
- means that insurance is fair
- r=pq, q=IH-Is
- Sub in values to previous equations - ANSWER Actuarially Fair Insurance
r= premium q= payout E(pi)= profit
E(pi(p,q,r))= (1-p)r + p(r-q)= r-pq - ANSWER Insurer Profits
- perfectly competitive: E(pi)=0, r=pq
- unfair: E(pi)>0, r>pq - ANSWER Fair and Unfair Insurance
Is'=IH'
q= IH-Is - ANSWER Full Insurance
- doesn't achieve state independence
Is'<IH'
q<IH-Is - ANSWER Partial Insurance
See Graphs - ANSWER Comparing Contracts
- ANSWER Chapter 8
2
, - incomplete information about the quality of a good - ANSWER Asymmetric Info
- asymmetric info
- can't tell quality of good, 1 price
- adverse selection, only low quality goods remain in the market therefore don't buy, market
failure - ANSWER Lemons Problem
- Buyers value cars 50% more than sellers
- M= utility from other goods, X= quality of car
Us= Xj+M, Ub= 3/2 Xj+M
- car quality uniform distribution
- will put car on market if P>Xj, buyers buy if 3/2E(Xj)>P this is not possible therefore no cars
sell
- assumptions: buyers don't know true quality of car, buyers know sellers utility and
distribution of cars, buyers know sellers withdraw highest quality cars -
ANSWER Akerlof Model
- transaction that leaves all parties at least no worse off - ANSWER Pareto Improving
Transaction
- over supply of low quality goods, products or contracts that results -
ANSWER Adverse Selection
- sellers try to convince buyers that cars are healthy, high quality bodies leave market when
universal premium is set
- Only least healthy people buy insurance - ANSWER Lemons Problem and Insurance
- successive rounds of adverse selection that destroy insurance markets
3
UPDATE!!!!!!2025/2026|GUARANTEED
ANSWER Chapter 7
- risk because there is a fear of the unknown
- forfeiting income in good times to get money in bad times - ANSWER Demand for
Insurance
U'(1)>0, utility increases with income
U''(1)<0, marginal utility for income is declining - ANSWER Risk Aversion
- probability of sickness= P (between 0 and 1)
- probability healthy= 1-p
- Is= income if sick
- IH>Is= income if healthy
E(I)= PIs + (1-P)U(IH) - ANSWER Uncertainty
- P=1
- E(U)= U(Is)= Is
- P=0
- E(U)=U(IH)= IH
SEE GRAPH - ANSWER Probability of Sickness
- customer pays up front fee
1
,- r= insurance premium
- if ill customer gets q- insurance pay out
- sick: IH+q-r
- healthy: Is+0-r
- optimal: Is'=IH', full insurance with no uncertainty - ANSWER Health Insurance
Contract
- means that insurance is fair
- r=pq, q=IH-Is
- Sub in values to previous equations - ANSWER Actuarially Fair Insurance
r= premium q= payout E(pi)= profit
E(pi(p,q,r))= (1-p)r + p(r-q)= r-pq - ANSWER Insurer Profits
- perfectly competitive: E(pi)=0, r=pq
- unfair: E(pi)>0, r>pq - ANSWER Fair and Unfair Insurance
Is'=IH'
q= IH-Is - ANSWER Full Insurance
- doesn't achieve state independence
Is'<IH'
q<IH-Is - ANSWER Partial Insurance
See Graphs - ANSWER Comparing Contracts
- ANSWER Chapter 8
2
, - incomplete information about the quality of a good - ANSWER Asymmetric Info
- asymmetric info
- can't tell quality of good, 1 price
- adverse selection, only low quality goods remain in the market therefore don't buy, market
failure - ANSWER Lemons Problem
- Buyers value cars 50% more than sellers
- M= utility from other goods, X= quality of car
Us= Xj+M, Ub= 3/2 Xj+M
- car quality uniform distribution
- will put car on market if P>Xj, buyers buy if 3/2E(Xj)>P this is not possible therefore no cars
sell
- assumptions: buyers don't know true quality of car, buyers know sellers utility and
distribution of cars, buyers know sellers withdraw highest quality cars -
ANSWER Akerlof Model
- transaction that leaves all parties at least no worse off - ANSWER Pareto Improving
Transaction
- over supply of low quality goods, products or contracts that results -
ANSWER Adverse Selection
- sellers try to convince buyers that cars are healthy, high quality bodies leave market when
universal premium is set
- Only least healthy people buy insurance - ANSWER Lemons Problem and Insurance
- successive rounds of adverse selection that destroy insurance markets
3
