7. If A is risk averse, (a) he is indifferent between receiving either $100 with
ID: 1127255 • Letter: 7
Question
7. If A is risk averse,
(a) he is indifferent between receiving either $100 with certainty or the prospect of a .5 chance of $200 and a .5 chance of $75.
(b) he prefers $100 with certainty to a gamble in which offers him a .3 chance of winning $500 and a .7 chance of keeping his $100.
(c) he prefers $100 with certainty to a gamble which offers him a .5 chance of $150 and a .5 chance of $50.
(d he is indifferent between two gambles that have an equal expected value—e.g., an equal chance of $150 and $50 or an equal chance of $200 and $0.
(e) he will buy insurance against the risk of an injury.
8. Suppose there is a chance that a child playing in the area of a construction project might fall in a large hole and injure itself. Constructing a fence around the project will prevent such an accident. Assume the harm from such an accident is $100,000, the probability of an accident equals .01 during the construction period, the cost of a fence is $5000, the contractor expects a profit of $25,000, and all parties are risk neutral. Strict liability will be inefficient because
(a) the contractor will install the fence which reduces expected wealth by $5000.
(b) it creates no incentive for children or their parents to take efficient levels of care to avoid an accident.
(c) the contractor may shut the project down rather than face a potential liability of $100,000.
(d) the contractor will install the fence under strict liability but not under negligence.
(e) all of the above.
9. Suppose ranchers are free to use an uncultivated pasture for grazing their cows. The Coase theorem implies that
(a) transactions costs will be minimized when one party acquires the pasture and charges for its use.
(b) inefficient over-grazing will end under common or private property if transaction costs among ranchers are negligible.
(c) ranchers are just as likely to eliminate inefficient over-grazing on common as on private property.
(d) a rancher has no incentive to internalize the harm caused by overgrazing in the absence of a rule that holds him liable for this harm.
(e) the choice between making the ranchers liable for the harm from overgrazing or converting the land to private property depends on the importance of transaction costs.
A
cut later
cut now
B
cut later
10, 10
0, 14
cut now
14, 0
6, 6
10. In a one period Prisoner’s game
(a) there are two Nash equilibria yielding the payoffs (10, 10) and (6, 6).
(b) the unique outcome (6, 6) is not a Nash equilibrium because individual maximizing behavior leaves the parties worse off than if they agree to delay cutting down the trees for a year
(c) the unique outcome (6, 6) is not Pareto superior.
(d) both (b) and (c) are correct.
(e) the parties will cut later because the combined payoff of 20 is greater than any other outcome.
A
cut later
cut now
B
cut later
10, 10
0, 14
cut now
14, 0
6, 6
Explanation / Answer
7. (e) he will buy insurance against the risk of an injury.
Explanation: Risk-averse people want to avoid risks. Risk-averse people buy insurance to avert a risk.
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