Chapter 15

Adverse Selection

MULTIPLE CHOICE

1. Adverse selection implies that:

a. the market for used cars is perfectly competitive

b. the market for used cars will contain more cars of higher than average quality
c. the market for used cars will contain more cars of lower than average quality
d. all used cars will be of equal quality
e. the government overinsures the market for used cars

ANS: C PTS: 1

2. From whom would you prefer to buy a used car, everything else being equal?

a. a mechanic
b. a used car dealer
c. a family that is moving to China
d. a person who is buying a new car
e. You would have no preference among these choices.

ANS: C PTS: 1

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 3. Suppose that in Milford, Connecticut, owners of used cars that are lemons value their cars at

$2,500, and owners of used cars that are reliable value their cars at $6,000. There are equal
quantities of each type of car on the market. Buyers value low-quality cars at $1,500 and
high-quality cars at $7,000. In this market:
a. only low-quality cars will be sold at a price of $1,500
b. only low-quality cars will be sold at a price of $2,500
c. all cars will sell at a price of $4,250
d. only high-quality cars will be sold at a price of $6,000
e. only high-quality cars will be sold at a price of $7,000

ANS: E PTS: 1

Please use the following information for questions 4–8.

Suppose the Ajax Insurance Company provides insurance for skydivers whose wealth before
diving is $400. An accident will leave divers with a wealth of $100. The company divides the
divers into two classes, safe (probability of an accident = 0.2) and unsafe (probability of an
accident = 0.5). The utility of wealth for all divers is given by the function: U(w) = w0.5.

4. Given this information, the divers are:

a. risk-averse
b. risk seeking
c. risk-neutral
d. indifferent to risk
e. risk-averse, risk seeking, or risk-neutral; we cannot tell from this information

ANS: A PTS: 1

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 5. The utility of no insurance for the safe diver is:

a. 15
b. 17.3
c. 18
d. 18.3
e. none of the above

ANS: C PTS: 1

6. If the insurance premium is $100:

a. both types of divers buy insurance

b. neither type of diver buys insurance
c. only the safe divers buy insurance
d. only the unsafe divers buy insurance

ANS: D PTS: 1

7. If the insurance premium is $50:

a. both types of divers buy insurance

b. neither type of diver buys insurance
c. only the safe divers buy insurance
d. only the unsafe divers buy insurance

ANS: A PTS: 1

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 8. If only the unsafe divers buy insurance and the premium is $100, the insurance company will:

a. earn a profit of $100 per unsafe diver

b. break even
c. incur a loss of $200 per unsafe diver
d. incur a loss of $300 per unsafe diver
e. experience none of the above

ANS: C PTS: 1

9. Most states require car owners to provide evidence that they have auto insurance when they

register their cars and obtain license plates. For the sellers of insurance policies, this may help
to limit the severity of the:
a. information asymmetry
b. moral hazard problem
c. signaling problem
d. adverse selection problem
e. Akerlof problem

ANS: D PTS: 1

10. Which of the following is the best example of adverse selection?

a. Smokers are more likely to obtain health insurance.

b. Safe drivers tend to get auto insurance.
c. All drivers are required to have auto insurance if they are to register their cars
legally in Connecticut.
d. Both healthy and unhealthy people tend to buy life insurance.
e. Given the existence of government-funded flood insurance, people continue to
build homes in flood plains.

ANS: A PTS: 1

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 11. Insurance companies are able to offset the adverse selection in markets for life insurance by:

a. requiring premiums that are above the expected value of receipts

b. only insuring people who appear to be sick
c. insuring a wide variety of people so that gains on some policies offset losses on
others
d. requiring medical exams from people whom they insure
e. requiring higher premiums from healthy people than from sick people

ANS: D PTS: 1

12. One way to solve the problem of adverse selection in markets for homeowner’s insurance is

to:
a. only insure customers who make claims against their policies
b. use deductibles to encourage safe behavior
c. offer premium discounts to people who install house alarm systems
d. require homeowner’s insurance as a condition of acquiring a mortgage
e. b, c, and d

ANS: E PTS: 1

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 Please use the following diagram to answer questions 13–15.

13. In this case, the best possible pricing scheme would:

a. encourage high-risk individuals to obtain full coverage

b. encourage all individuals to obtain full coverage
c. establish a single premium for all individuals
d. encourage only low-risk individuals to buy any insurance
e. result in no coverage purchased by low- or high-risk individuals

ANS: A PTS: 1

14. In this case, the high-risk individuals choose:

a. the full coverage policy

b. the partial coverage policy
c. no coverage
d. none of the above

ANS: A PTS: 1

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 15. In this case, the low-risk individuals choose:

a. the full coverage policy

b. the partial coverage policy
c. no coverage
d. none of the above

ANS: A PTS: 1

16. The signaling model of education would be ineffective if:

a. skills learned in school were useful in employment and could be effectively tested
b. the costs of acquiring education were equal for individuals of different abilities
c. individuals could not identify their own abilities
d. b and c
e. all of the above

ANS: D PTS: 1

17. Requiring applicants for life insurance to undergo a physical examination is an effective way

to:
a. reduce moral hazard
b. increase information asymmetry
c. reduce adverse selection
d. increase sales
e. none of the above

ANS: C PTS: 1

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 18. Which of the following is a credible signal of product quality?

a. a money back guarantee

b. high price
c. a warrantee
d. assurances by a salesperson
e. a and c

ANS: E PTS: 1

Use the information that follows to answer questions 19 and 22. Good drivers have a 20 percent
chance, and bad drivers have a 50 percent chance, of getting in an accident. A car is worth $900,
and an accident would reduce its value to $400. Both types of drivers have utility U = (car
value)0.5?

19. What is a good driver’s expected utility without insurance?

a. 20
b. 25
c. 28
d. 30
e. none of the above

ANS: C PTS: 1

20. What is a bad driver’s expected utility without insurance?

a. 20
b. 25
c. 28
d. 30
e. none of the above

ANS: B PTS: 1

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 21. If an insurance policy costs $200 and will pay $400 in case of an accident, what decision will

be made by the two drivers?

a. Both drivers will buy insurance.
b. Neither driver will buy insurance.
c. The good driver will buy insurance and the bad driver won’t.
d. The bad driver will buy insurance and the good driver won’t.

ANS: D PTS: 1

22. If an insurance policy costs $80 and will pay $400 in case of an accident, what decision will

be made by the two drivers?

a. Both drivers will buy insurance.
b. Neither driver will buy insurance.
c. The good driver will buy insurance and the bad driver won’t.
d. The bad driver will buy insurance and the good driver won’t.

ANS: A PTS: 1

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