Risk information and insurance

• What roles does information asymmetry play in the insurance market?

  Adverse selection and moral hazard
• What is adverse selection in the insurance market?

  Individuals know their own risk better than insurers
• What causes information asymmetry in adverse selection?

  Hidden information about individual risk levels
• Who typically buys insurance due to adverse selection?

  Individuals with high risk
• What is moral hazard in the insurance market?

  Insurers cannot observe actions of the insured
• What does hidden action refer to in moral hazard?

  Actions taken by the insured after signing
• What happens if the insured is fully insured?

  They may not take actions to reduce risk
• What influences the actions of the insured when they have partial coverage?

  The trade-off between deductible and action cost
• What determines an individual's choice between Lottery A and Lottery B?

  The individual's risk attitude
• What will a risk-loving individual choose between two lotteries?

  They will choose the riskier lottery
• What does a risk-neutral individual care about when choosing a lottery?

  Only the expected prize
• How does a risk-averse individual choose between lotteries?

  By comparing expected prize and risk
• What is the selling price of a pizza in the scenario?

  $10
• What can leftover pizzas be sold for?

  $1.25 each
• What is the cost of disappointed customers?

  $0.25 each
• What are the decision alternatives for the pizza shop owner?

  Make 20, 40, or 50 pizzas
• What are the states of nature in the pizza shop scenario?

  Demand of 20, 40, or 50 pizzas
• How is revenue calculated in the pizza shop scenario?

  Number of pizzas sold * $10 + leftovers * $1.25
• How is cost calculated in the pizza shop scenario?

  Number of pizzas made * $4.25 + disappointed customers * $0.25
• What are the payoffs in the pizza shop scenario?

  Revenues - Costs
• What is the payoff table for the pizza shop scenario?

  | Demand | 20 Pizzas | 40 Pizzas | 50 Pizzas |

  |--------------|-----------|-----------|-----------|

  | Supply | | | |

  | 20 Pizzas | $115 | $110 | $107.5 |

  | 40 Pizzas | $55 | $230 | $227.5 |

  | 50 Pizzas | $25 | $200 | $287.5 |
• What is the Maximax decision for the pizza shop owner?

  Make 50 pizzas
• What is the Maximin decision for the pizza shop owner?

  Make 20 pizzas
• What is self-insurance in the context of risk aversion?

  Taking action to reduce loss from bad events
• What is the cost associated with self-insurance?

  It incurs a cost denoted as $c$
• What happens to prospective loss when cost $c$ is incurred?


  It becomes $L(c)$, where $L'(c) < 0$
• What is the individual's wealth if they are self-insured and the bad event does not happen?

  $W - c$
• What is the individual's wealth if the bad event happens while self-insured?

  $W - L(c) - c$
• What is the expected utility for a self-insured individual?

  $(1 - p)U(W - c) +$$pU(W - L(c) - c)$
• What is the first-order condition for maximizing expected utility in self-insurance?

  $(1 - p)U'(W - c) +$$pU'(W - L(c) - c)(L'(c) +$$1) =$$0$
• What is the necessary condition for an individual to be self-insured?

  $L'(c) < -1$
• Why is self-insurance unlikely to be seen in practice?

  Probability of bad events is usually very small
• What does a very negative value of $- \frac{1 - p}{p} U'(W - c) / U'(W - L(c) - c)$ imply?


  Loss reduction must be highly effective
• What does $L'(c) =$$- \frac{1 - p}{p} U'(W - c) / U'(W - L(c) - c) - 1$ indicate?


  It will be a very large negative number
• What is the cost of one lottery ticket?

  $1
• How do you calculate the standard deviation of lottery ticket prizes?

  Using the formula provided in the text
• Why will Richard, known as "No-Risk Rick," not buy the lottery ticket?

  The risk is not compensated by expected value
• What is Richard's utility function?


  𝑈 = √𝑊
• What actions might the state take regarding the lottery based on the losses?

  Raise ticket prices or reduce prizes
• What is Natasha's utility function?

  𝑈(��) = √10𝐼