Problem 1. A bidders' value for a good may be low ($2), medium ($5), or high ($7). There are an equal number of potential bidders having each value. Suppose two bidders show up for an auction at which the good is offered. What is the best estimate of the expected revenue from the auction assuming there is no minimum bid increment?
a. $4.11
b. $3.99
c. $3.56
d. $5.00
Problem 2. Suppose that you have 2 buyers. The first buyer values your product at $10, and the second buyer values your product at $6. You estimate that the probability of getting a high valued customer is 40%. Your marginal costs are $3. What is your optimal price and expected profit?
a. Price at $6, Profit = $1
b. Price at $6, Profit = $3
c. Price at $10, Profit = $1
d. Price at $10, Profit = $4
Problem 3. An oral auction with values of $4, $6, $9, $12, $13, and $15 is currently taking place. What will the winning bidder pay?
a. 10
b. 11
c. 13
d. 15
Problem 4. The demand for insurance arises from people who are:
a. Risk-seeking
b. Risk-neutral
c. Risk-averse
d. None of the above
Problem 5. Your firm is considering investing in a new project. If the economy is strong (30% probability), you expect an NPV of $500,000; if the economy is normal (50% probability), you expect an NPV of $400,000; and if the economy is weak (20% probability), you expect an NPV of $300,000. What is the expected NPV of the project?
a. $390,000
b. $400,000
c. $410,000
d. None of the above
Problem 6. Which of the following is an example of an effective screening technique?
a. A car maker advertising the high-quality of their car
b. A customer providing an insurance company with his/her credit report
c. A company asking the average speed you drive
d. A person who decides to pursue his MBA
Problem 7. If you were attempting to reduce the possibility of moral hazard with your employees using corporate car insurance, you would NOT:
a. Hire a private investigator to follow your employees while they drive
b. Reward employees for safe driving
c. Remove all the safety features from your employees’ cars
d. Try to determine which employees are safe drivers before offering them insurance
Problem 8. Antilock brakes, airbags, and seatbelts increased the number of accidents while simultaneously decreasing the number of fatal accidents. Why does this happen?
a. Adverse Selection
b. Screening
c. Signaling
d. Moral Hazard
e. None of the above
Problem 9. In a principal-agent relationship, the principal’s goal is to. . .
a. control the agent
b. pay the agent
c. align agent’s incentives with principal’s goals
d. eradicate shirking
Problem 10. A fifth-grade entrepreneur decides to sell playground protection. He decides he will pay protection holders $5 if they get beat up by the playground bully ($5 is a rough estimate of the monetary value of the pain a beaten-up student experiences). On the playground, 20% of the kids are wimps, and 80% are not. The probability that a non-wimp will get beat up by the bully is .3. This probability doubles for wimps. Assuming the kids know if they are wimps or not, where should the entrepreneur price his protection policy (pricing at fair value)?
a. $1.80
b. $3.00
c. $1.00
d. $1.50
Problem 11. When you buy a set of speakers, Best Buy asks if you would like to purchase insurance for your speakers. Assume that paying for new speakers for customers who listen to music at a reasonable level (thus minimizing damage) costs on average $150, and paying for new speakers for customers who listen to music very loudly (more likely to damage the speakers) costs on average $1000. Individuals know whether they like music at a reasonable level or at a loud level, but Best Buy can assume that 40% of listeners are reasonable listeners, and 60% are loud listeners. How much does Best Buy have to charge in order to break even?
a. $660
b. $1000
c. $150
d. $575
Problem 12. A suntan lotion company is interested in expanding to another market. In Miami, there is a 60% chance of selling 5,000 units at a $5 profit/unit, a 20% chance of selling 4,000 at a $8 profit/unit, and a 20% chance of losing $5,000. In Las Vegas, there is a 70% chance of selling 5,000 units at a $6 profit/unit, a 20% chance of selling 4,000 at a $7 profit/unit, and a 10% chance of losing $5,000. Finally, in San Diego, there is a 40% chance of selling 8,000 units at a $9 profit/unit, a 20% chance of selling 4,000 at a $9 profit/unit, and a 40% chance of losing $20,000. To enter each market there is a cost of $15,000. What market should the company enter?
a. Miami
b. Las Vegas
c. San Diego
d. Do not enter any market
Problem 13. You take a position with a large real estate development company as your first job after graduation. Your first big assignment is to sell an office building – you have been informed the company’s cost into the building (and the bottom line price it is willing to accept) is $400,000. You have identified a likely buyer and you assess that his top price is either $500,000 with a probability of .3, $600,000 with a probability of .5, or $1,000,000 with a probability of .2. You have to commit to a posted price – what price will maximize your profitability?
Problem 14. Assume you paid $3,000 for your notebook computer. The probability of the computer being stolen is .02 if you are careful and .05 if you are not. How much (in dollar terms) are you willing to expend in caring for the computer? If you had purchased insurance that replaced the computer if it were stolen, how much would you be willing to spend in taking care of it (ignore the “costs” of lost data and time in getting a replacement)? Why? What is the problem the computer company faces in offering insurance? What is one way it might deal with this problem?
Problem 15. An insurance company would like to offer theft insurance for renters. The policy would pay the full replacement value of any items that were stolen from the apartment. Some apartments have security alarms installed. Such systems detect a break-in and ring an alarm within the apartment. The insurance company estimates that the probability of a theft in a year is .05 if there is no security system and .01 if there is a security system (there cannot be more than one theft in any year). An apartment with a security system costs the renter an additional $50 per year. Assume that the dollar loss from a theft is $10,000 and that the insurance company is risk neutral and the renter would be willing to pay more than the expected loss to insure against the loss of theft.
a. What is the insurance company's break even price for a one year theft insurance policy for an apartment without a security system?
b. Does a renter have incentive to pay for a security system if he does not have insurance? To answer this question you must calculate the expected cost to the renter with and without a security system.
c. For a security system to be effective the renter must turn it on whenever he or she leaves the apartment. Suppose it costs the renter $10 per year in expended effort to turn on the alarm system. What is the insurance company's break even price for a one year theft insurance policy for an apartment with a security system? (HINT: Moral Hazard)
d. What deductible amount would provide sufficient incentive for the renter to turn on the alarm system each time he or she leaves the apartment?
e. What is the insurance company's break even price for a one year theft insurance policy with that deductible amount for an apartment with a security system?