TB Ch15 Risk And Information PDF

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File: ch15, Chapter 15: Risk and InformationMultiple Choice In economics, a lottery is a) the likelihood that a particular outcome occurs. b) a depiction of all possible outcomes of an event and their associated probabilities. c) any event for which the outcome is uncertain. d) a measure of risk ass...

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Besanko & Braeutigam – Microeconomics, 4th editionTest Bank

File: ch15, Chapter 15: Risk and Information

Multiple Choice

1.

In economics, a lottery is a) the likelihood that a particular outcome occurs. b) a depiction of all possible outcomes of an event and their associated probabilities. c) any event for which the outcome is uncertain. d) a measure of risk associated with some event.

Ans: C Difficulty: Easy Heading: Describing Risky Outcomes LO 1 Describe risky outcomes using the concepts of probability, expected value, and variance.

2.

Which of the following statements is false? a) Some probabilities result from laws of nature; some reflect subjective beliefs about risky events. b) The probability of any particular outcome is between 0 and 1. c) The sum of the probabilities of all possible outcomes can exceed one. d) The sum of the probabilities of all possible outcomes must equal exactly one.

Ans: C Difficulty: Easy Heading: Describing Risky Outcomes LO 1 Describe risky outcomes using the concepts of probability, expected value, and variance.

3.

The expected value of a lottery is a) the average payoff you would get from the lottery if the lottery were repeated many times. b) the sum of the probability-weighted squared deviations of the possible outcomes of the lottery. c) a measure of risk preference. d) the amount an individual would be willing to pay to enter a lottery.

Ans: A Difficulty: Easy Heading: Describing Risky Outcomes

Copyright © 2011 John Wiley & Sons, Inc.

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Besanko & Braeutigam – Microeconomics, 4th editionTest Bank

LO 1 Describe risky outcomes using the concepts of probability, expected value, and variance.

4.

Suppose a fair, two-sided coin is flipped. If it comes up heads you receive $5; if it comes up tails you lose $1. The expected value of this lottery is a) $2 b) $3 c) $4 d) $5

Ans: A Difficulty: Medium Heading: Describing Risky Outcomes LO 1 Describe risky outcomes using the concepts of probability, expected value, and variance.

5.

The variance of a lottery is a) the average payoff you would get from the lottery if the lottery were repeated many times. b) the sum of the probability-weighted squared deviations of the possible outcomes of the lottery. c) a measure of risk preference. d) the amount an agent would be willing to pay to enter a lottery.

Ans: B Difficulty: Easy Heading: Describing Risky Outcomes LO 1 Describe risky outcomes using the concepts of probability, expected value, and variance.

6.

Suppose a fair, two-sided coin is flipped. If it comes up heads you receive $5; if it comes up tails you lose $1. The variance of this lottery is a) 4.5 b) 9.0 c) 13.5 d) 18.0

Ans: B Difficulty: Medium Heading: Describing Risky Outcomes LO 1 Describe risky outcomes using the concepts of probability, expected value, and variance.

Copyright © 2011 John Wiley & Sons, Inc.

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Besanko & Braeutigam – Microeconomics, 4th editionTest Bank

7.

Consider a lottery with four equally likely outcomes, A, B, C, and D. The associated payoffs are: A - $10, B - $30, C - $70, and D - $150. The expected value of this lottery is a) $30 b) $65 c) $130 d) $260

Ans: B Difficulty: Medium Heading: Describing Risky Outcomes LO 1 Describe risky outcomes using the concepts of probability, expected value, and variance.

8.

Consider a lottery with four equally likely outcomes, A, B, C, and D. The associated payoffs are: A - $10, B - $30, C - $70, and D - $150. The variance of this lottery is a) 2,875 b) 5,750 c) 8,625 d) 11,500

Ans: A Difficulty: Medium Heading: Describing Risky Outcomes LO 1 Describe risky outcomes using the concepts of probability, expected value, and variance.

9.

Consider a lottery with four possible outcomes, A, B, C, and D. The associated payoffs are: A - $10, B - $30, C - $70, and D - $150. The probabilities are P( A) 0.40 ,

P( B) 0.20 , P(C ) 0.30 , and P( D) 0.10 . The expected value of this lottery is a) $23 b) $46 c) $65 d) $260 Ans: B Difficulty: Medium Heading: Describing Risky Outcomes LO 1 Describe risky outcomes using the concepts of probability, expected value, and variance.

Copyright © 2011 John Wiley & Sons, Inc.

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Besanko & Braeutigam – Microeconomics, 4th editionTest Bank

10.

Consider a lottery with four possible outcomes, A, B, C, and D. The associated payoffs are: A - $10, B - $30, C - $70, and D - $150. The probabilities are P( A) 0.40 ,

P( B) 0.20 , P(C ) 0.30 , and P( D) 0.10 . The variance of this lottery is a) 912 b) 1,824 c) 1,618 d) 3,326 Ans: B Difficulty: Medium Heading: Describing Risky Outcomes LO 1 Describe risky outcomes using the concepts of probability, expected value, and variance.

11.

Consider four lotteries, A, B, C, and D, all with an expected value of $100. The associated standard deviations of the lotteries are: A is 10, B is 15, C is 5, and D is 20. Which lottery is the riskiest? a) Lottery A b) Lottery B c) Lottery C d) Lottery D

Ans: D Difficulty: Easy Heading: Describing Risky Outcomes LO 1 Describe risky outcomes using the concepts of probability, expected value, and variance.

**Reference: Use the following probability distribution for a lottery to answer the next two questions (12-13).

Copyright © 2011 John Wiley & Sons, Inc.

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Besanko & Braeutigam – Microeconomics, 4th editionTest Bank

$150

$140

$130

$120

$110

$100

$90

$80

$70

$60

$50

$40

$30

$20

0.45 0.40 0.35 0.30 0.25 0.20 0.15 0.10 0.05 0.00 $10

Probability

Probability Distribution

Payoff

12.

*Given the probability distribution for the lottery above, what is the expected value of this lottery? a) $83 b) $71 c) $68 d) $65

Ans: C Difficulty: Medium Heading: Describing Risky Outcomes LO 1 Describe risky outcomes using the concepts of probability, expected value, and variance.

13.

*Given the probability distribution for the lottery above, what is the standard deviation of this lottery? a) 2,401 b) 2,116 c) 49 d) 46

Ans: D Difficulty: Medium Heading: Describing Risky Outcomes LO 1 Describe risky outcomes using the concepts of probability, expected value, and variance.

Copyright © 2011 John Wiley & Sons, Inc.

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Besanko & Braeutigam – Microeconomics, 4th editionTest Bank

14.

Suppose you purchase a collectible baseball card from an acquaintance for $50. You think it could be worth $1,000 with a 10% probability and $0 with a 90% probability. What is your expected value for the baseball card? a) $150 b) $100 c) $1000 d) $50

Ans: B Difficulty: Easy Heading: Describing Risky Outcomes LO 1 Describe risky outcomes using the concepts of probability, expected value, and variance.

15.

The variance of a probability distribution can be described as a) a measure of the riskiness of a probability distribution and is calculated by finding the square root of the probability-weighted squared deviations of the possible outcomes. b) a measure of the riskiness of a probability distribution and is calculated by finding the probability-weighted squared deviations of the possible outcomes times two. c) a measure of the amplitude of a probability distribution and is calculated by finding the square root of the probability-weighted squared deviations of the possible outcomes. d) a measure of the riskiness of a probability distribution and is calculated by finding the probability-weighted squared deviations of the possible outcomes.

Ans: D Difficulty: Medium Heading: Describing Risky Outcomes LO 1 Describe risky outcomes using the concepts of probability, expected value, and variance.

16.

What would be the expected value, variance and standard deviation of an event that always took the value one as its outcome? a) 1, 1, 1 b) 1, 0, 1 c) 1, 0, 0 d) 1, 1, 0

Ans: C Difficulty: Medium Heading: Describing Risky Outcomes LO 1 Describe risky outcomes using the concepts of probability, expected value, and variance.

Copyright © 2011 John Wiley & Sons, Inc.

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Besanko & Braeutigam – Microeconomics, 4th editionTest Bank

17.

Given the possible outcomes to a lottery being only the values 2, 6 with equal probabilities, calculate the expected value, variance and standard deviation? a) EV = 4, variance = 16, standard deviation = 4 b) EV = 4, variance = 4, standard deviation = 2 c) EV = 4, variance = 4, standard deviation = 4 d) EV = 3.5, variance = 4, standard deviation = 2

Ans: B Difficulty: Hard Heading: Describing Risky Outcomes LO 1 Describe risky outcomes using the concepts of probability, expected value, and variance.

18.

A person who gets increasing marginal utility as income increases is described as a) risk-averse. b) risk-neutral. c) risk-loving. d) risk-gaining.

Ans: C Difficulty: Easy Heading: Evaluating Risky Outcomes LO 2 Illustrate how the shape of an individual's utility function describes his or her attitudes toward risk.

19.

Large firms that can take on a number of small investment projects whose returns are independent of each other would most likely be characterized as a) risk-averse, because large firms do not like to take any risk. b) risk-neutral, because each investment project is small relative to the total and firms are incentivized to maximize profits. c) risk-loving, because there are a lot of benefits to being the biggest and most powerful firm. d) risk-gaining, because there are a lot of benefits to being the biggest and most powerful firm.

Ans: B Difficulty: Hard Heading: Evaluating Risky Outcomes LO 2 Illustrate how the shape of an individual's utility function describes his or her attitudes toward risk.

Copyright © 2011 John Wiley & Sons, Inc.

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Besanko & Braeutigam – Microeconomics, 4th editionTest Bank

20.

Which of the following statements is incorrect? a) A risk-averse decision maker will choose the alternative with the lowest variance among alternatives with identical expected utilities. b) A risk-neutral decision maker will always choose the alternative with the lowest variance among alternatives with identical expected utilities. c) A risk-loving decision maker will choose the alternative with the highest variance among alternatives with identical expected utilities. d) The expected utility of a lottery is the expected value of the utility levels that the decision maker receives from the payoffs in the lottery.

Ans: B Difficulty: Easy Heading: Evaluating Risky Outcomes LO 2 Illustrate how the shape of an individual's utility function describes his or her attitudes toward risk.

21.

A decision maker can be described with utility which is only a function of income and which exhibits diminishing marginal utility of income. This decision maker is a) risk-averse. b) risk-neutral. c) risk-loving. d) risk-gaining.

Ans: A Difficulty: Easy Heading: Evaluating Risky Outcomes LO 2 Illustrate how the shape of an individual's utility function describes his or her attitudes toward risk.

22.

A decision maker can be described with utility which is only a function of income. If this function is linear, the decision maker is a) risk-averse. b) risk-neutral. c) risk-loving. d) risk-gaining.

Ans: B Difficulty: Easy Heading: Evaluating Risky Outcomes

Copyright © 2011 John Wiley & Sons, Inc.

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Besanko & Braeutigam – Microeconomics, 4th editionTest Bank

LO 2 Illustrate how the shape of an individual's utility function describes his or her attitudes toward risk.

23.

A decision maker has a utility function U  I . This decision maker is a) risk-averse. b) risk-neutral. c) risk-loving. d) risk-gaining.

Ans: A Difficulty: Easy Heading: Evaluating Risky Outcomes LO 2 Illustrate how the shape of an individual's utility function describes his or her attitudes toward risk.

24.

2 A decision maker has a utility function U I  500 . This decision maker is a) risk-averse. b) risk-neutral. c) risk-loving. d) risk-gaining.

Ans: C Difficulty: Easy Heading: Evaluating Risky Outcomes LO 2 Illustrate how the shape of an individual's utility function describes his or her attitudes toward risk.

25.

A decision maker has a utility function U = 10I. This decision maker is a) risk-averse. b) risk-neutral. c) risk-loving. d) risk-gaining.

Ans: B Difficulty: Easy Heading: Evaluating Risky Outcomes LO 2 Illustrate how the shape of an individual's utility function describes his or her attitudes toward risk.

Copyright © 2011 John Wiley & Sons, Inc.

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Besanko & Braeutigam – Microeconomics, 4th editionTest Bank

26.

Suppose a decision maker has a utility function U  I and is faced with a lottery where there is a 30% chance of earning $30 and a 70% chance of earning $80. What is the expected utility of this lottery? a) 7.6 b) 7.9 c) 8.2 d) 8.5

Ans: B Difficulty: Medium Heading: Evaluating Risky Outcomes LO 3 Calculate expected utility as a way to evaluate risky outcomes.

27.

A risk premium is a) a payment to an insurer by a policy-holder who faces a potential loss. b) equal to the purchase price of an insurance policy. c) the necessary difference between the expected value of a lottery and the payoff of a sure thing to make the decision maker indifferent between the lottery and the sure thing. d) the difference between the expected value and the variance of a lottery.

Ans: C Difficulty: Easy Heading: Bearing and Eliminating Risk LO 4 Compute the risk premium for a risk-averse decision maker.

28.

A risk premium, RP, can be computed with the following formula, where I1 and I2 are the two payoffs to a lottery, with probabilities p and (1-p), respectively : a) p(I1) + (1-p)I2 = RP b) pU(I1) + (1-p)U(I2) = RP c) pU(I1) + (1-p)U(I2) = U(EV-RP) d) U(EV) = RP

Ans: C Difficulty: Easy Heading: Bearing and Eliminating Risk LO 4 Compute the risk premium for a risk-averse decision maker.

Copyright © 2011 John Wiley & Sons, Inc.

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Besanko & Braeutigam – Microeconomics, 4th editionTest Bank

29.

A decision-maker is faced with a choice between a lottery with a 30% chance of a payoff of $30 and a 70% chance of a payoff of $80, and a guaranteed payoff of $65. If the decision maker’s utility function is U = this choice? a) $1.59 b) $2.52 c) $0 d) $3.95

√I

, what is the risk premium associated with

Ans: B Difficulty: Medium Heading: Bearing and Eliminating Risk LO 4 Compute the risk premium for a risk-averse decision maker.

30.

A decision-maker is faced with a choice between a lottery with a 30% chance of a payoff of $30 and a 70% chance of a payoff of $80, and a guaranteed payoff of $65. If the decision maker’s utility function is U I  500 , what is the risk premium associated with this choice? a) $0 b) $1 c) $2 d) $3

Ans: A Difficulty: Medium Heading: Bearing and Eliminating Risk LO 4 Compute the risk premium for a risk-averse decision maker.

31.

Lotteries A and B have the same expected value, but B has larger variance. Which of the following statements is true, all else equal? a) If the decision maker is risk averse, lottery A will have the larger risk premium. b) If the decision maker is risk neutral, lottery B will have the larger risk premium. c) If the decision maker is risk loving, both lotteries will have a positive risk premium. d) If the decision maker is risk averse, lottery B will have the larger risk premium.

Ans: D Difficulty: Easy Heading: Bearing and Eliminating Risk LO 4 Compute the risk premium for a risk-averse decision maker.

Copyright © 2011 John Wiley & Sons, Inc.

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Besanko & Braeutigam – Microeconomics, 4th editionTest Bank

32.

Consider an insurance policy with $15,000 worth of coverage. If there is a 10% chance the owner of the policy will file a claim for the $15,000 (and a 90% chance they will not file a claim), a fair price for this policy is a) $1,000 b) $1,500 c) $13,000 d) $13,500

Ans: B Difficulty: Easy Heading: Bearing and Eliminating Risk LO 4 Compute the risk premium for a risk-averse decision maker.

33.

An insurance company that sells fairly-priced insurance policies to a large number of individuals with similar realized accident risk probabilities should expect to a) break even. b) lose money. c) make a profit. d) sell policies to individuals with all types of risk preference.

Ans: A Difficulty: Easy Heading: Bearing and Eliminating Risk LO 4 Compute the risk premium for a risk-averse decision maker.

34.

Your current disposable income is $10,000. There is a 10% chance you will get in a serious car accident, incurring damage of $1,900. (There is a 90% chance that nothing will happen.) Your utility function is price of this policy? a) $100 b) $190 c) $199 d) $270

U= √ I , where I is income. What is the fair

Ans: B Difficulty: Medium Heading: Bearing and Eliminating Risk LO 4 Compute the risk premium for a risk-averse decision maker.

Copyright © 2011 John Wiley & Sons, Inc.

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Besanko & Braeutigam – Microeconomics, 4th editionTest Bank

35.

Your current disposable income is $10,000. There is a 10% chance you will get in a serious car accident, incurring damage of $1,900. (There is a 90% chance that nothing will happen.) Your utility function is U= √ I , where I is income. If this policy is priced at $40, what is the change in your expected utility if you purchase the policy rather than no insurance? a) 1 b) 0.8 c) 0.2 d) 0

Ans: B Difficulty: Medium Heading: Bearing and Eliminating Risk LO 4 Compute the risk premium for a risk-averse decision maker.

36.

Your current disposable income is $10,000. There is a 10% chance you will get in a serious car accident, incurring damage of $1,900. (There is a 90% chance that nothing will happen.) Your utility function is U= √ I , where I is income. What is the most you would be willing to pay for this policy (rather than no insurance)? a) $100 b) $190 c) $199 d) $270

Ans: C Difficulty: Medium Heading: Bearing and Eliminating Risk LO 4 Compute the risk premium for a risk-averse decision maker.

37.

A fairly-priced insurance policy is one in which a) the insurance premium is equal to the expected value of the promised insurance payment. b) the insurance premium is equal to the expected value of the promised insurance payment plus a small profit for the insurance company. c) the insurance premium is equal to the variance of the expected value of the promised insurance payment. d) the insurance premium is equal to the variance of the expected value of the promised insurance payment plus a small profit for the insurance company.

Ans: A Difficulty: Medium Heading: Bearing and Eliminating Risk Copyright © 2011 John Wiley & Sons, Inc.