Answers to Problems of Chapter 7

1.

Solution: You are willing to pay the average price. If the distribution of car values is symmetric,
you are willing to pay $22,000 for a randomly selected car.

2.

Solution: You are willing to pay the average price upfront: $22,000. However, the dealer will
know this, and only sell you a car worth between $20,000 and $22,000. But you know
this. So you will only pay $21,000. And so on. This ends with you paying $20,000,
and the car being worth $20,000.
This is OK for you, but the dealer can never sell cars worth more than $20,000. The
resolution, of course, is to get more information. This may include a test drive,
mechanical inspection, warranty, etc.

3.

Solution: Let P be the percent of profits you pay Ricky.

If Ricky is lazy, his expected payment is
0.60  10,000 P  0.40  50,000 P  26,000 P
If Ricky works hard, his expected payment is
0.20  10,000 P  0.80  50,000 P  1,000  42,000 P  1,000
To induce Ricky to work hard, you need
42,000 P  1,000  26,000 P
16,000 P  1,000
P  0.0625
So, offer Ricky 6.25% of the profits, and this should induce him to work hard.

1
4.
Solution: With full insurance:
Without a seawall, the expected loss is
400,000  0.02  8,000
With a seawall, the expected loss is
400,000  0.005  2,000
The insurance company will charge the expected loss as a premium. Your expected
cost under either scenario each year is the premium.
With partial insurance:
Without a seawall, the expected loss is
300,000  0.02  6,000
With a seawall, the expected loss is
300,000  0.005  1,500
The insurance company will charge the expected loss as a premium. Your expected
cost each year is:
Without a seawall:
[0.02  (300,000  400,000)  0.98 (0)]  6,000  8,000
With a seawall:
[0.005  (300,000  400,000)  0.98 (0)]  1,500  2,000
Unfortunately, neither insurance policy is better or worse. Although the premiums
under the partial insurance policy are lower, the expected cost each year is the same as
with full insurance. In either scenario, you will build the seawall if the annual cost of
building and maintaining a seawall is less than $6,000/year.