Topics in Economic Analysis 1 (TEA1) - Block 1

Problem Set 1 (Tutorials Weeks 2-3)

1. Greg is a thrifty fellow and his savings are 90,000. Using his savings money, he got a luxury sports car at 50,000. The probability that his car will be stolen (and never recovered) within the next year is 0.2. His utility function is u(w) = w, where w is wealth (which also includes cars value). Ignore cars depreciation. Suppose that Greg can lower the probability of theft to 0.1 by parking the car in an underground garage at a yearly cost of 599. (a) Show that in the absence of insurance, Greg will choose to park in the underground garage. (b) Suppose the insurance company can oer Greg a full coverage at a total cost 5,000 on the assumption that Greg parks his car in the underground garage. If it is impractical for the insurance company to monitor where Greg parks his car, what will be the prots of the insurer? (c) Identify the type of asymmetric information problem, and explain why does it arise here. 2. Consider Greg from the Problem 1. We know that in the absence of monitoring, oering full insurance coverage is impractical. (a) Suppose some insurance company oered Greg a policy where, in the event of theft, the payout, X is less than the value of the car, and that the cost of coverage per $1 of coverage is $0.10. Verify that for the insurance company to break even, the maximum value of X must be 44,083.5 (you do not need to derive this value). What is the expected utility that Greg would get in this case? (b) Suppose instead another insurance company oered Greg a policy where in the event of theft, the insurance company will only cover percent of $50, 000 value of the car, and that the cost of coverage per $1 of coverage is $0.10. Find the maximum value of that would allow the insurance company to break even. 3. Rock music lovers are more likely to lose their expensive watches then are jazz music lovers. Specically, there is an 80 percent probability that a rock-lover will lose a 1,000 watch during a year, but only a 20 percent probability that a jazz lover will. Rock lovers and jazz lovers are equally represented in the population. Assume that music taste is not observable by insurers (say, because the insurance is purchased via mail or on the web). (a) If the insurance company assumes that rock lovers and jazz lovers are equally likely to buy watch-loss insurance, what should the actuarially fair on average insurance premium per unit of coverage? 1

(b) If rock lovers and jazz lovers have logarithmic utility of wealth functions (i.e. U (w) = ln(w)) and current wealth of 10,000 (including the value of the watch) each, will these individuals buy full insurance at the premium calculated in part (a)? (c) Given your answer in part (b), what are the implications of the behavior of rock lovers and jazz lovers for the insurers prots? (d) Given your results from part (c), is there any other single total insurance premium that you would recommend the competitive insurer to charge? Why? Calculate the utility for each type of person in this case. (e) Identify the type of asymmetric information problem, and explain why does it arise here. Discuss how the asymmetric information problem aects the welfare of music lovers when only a single premium insurance contracts are oered. 4. Consider music lovers from problem 3. We know that oering a single insurance contract is not practical if the music taste is not observable. Suppose that an insurance company charged dierent total premiums for rock-lovers and jazz-lovers. Design insurance contracts that allow a competitive insurer to stay in business even in the presence of asymmetric information and no possibility of monitoring. Verify that the maximum coverage that one of the contracts would involve is 12.644 (you do not need to derive this value). What are the expected utilities that the music lovers would derive as a result? 5. * Consider Barbara, whose only asset is her house currently valued at L = 625 currency units. Let her utility over monetary values be of the form v(w) = w, and suppose that she only cares about the monetary value of her house. In the event of a re, she loses the entire value of her house. Suppose she can take care, e with e [2, 3] units of care. Suppose that the probability that the house catches re as a function of care e is p(e) = 1 , and suppose that disutility of care is d(e) = 0.5e2 . Let us further e suppose that Barbaras disutility of care d(e) is separable from her monetary utility, i.e. her total expected utility consists of expected utility over monetary values and her disutility of care, i.e. EU (w, e) = Ev(w) d(e). (a) What is Barbaras optimal choice of care in the absence of insurance? (b) Suppose Barbaras level of care is observable, and an insurer oers her an actuarially fair full coverage based on her level of care. Verify that Barbaras optimal choice of care is about 2.52434 units of care (you do not need to derive this value). (c) Using the rst order conditions of the parts (a) and (b), show that Barbara would take less care when full insurance is available than in the absence of it. (d) Suppose that the insurer oered a contract given Barbaras choice in part (b). What would Barbara choose if her care was unobservable? What would be the insurers prot?