Chapter 27. The Basic Toolsof money management. Problems and Applications (5-9) Gregory Mankiw. Principles of Economics 7th Edition.
5. For each of the following kinds of assurance, give an example of behavior that can be called moral hazard and another example of behavior that can be called adverse selection.
a. health assurance
b. car assurance
6. Which kind of stock would you expect to pay the higher average return: stock in an field that is very sensitive to economic conditions (such as an automaker) or stock in an field that is relatively insensitive to economic conditions (such as a water enterprise)? Why?.
7. A enterprise faces two kinds of uncertainty. A firm-specific uncertainty is that a competitor might enter its sector and take some of its customers. A sector uncertainty is that the economy might enter a recession, reducing sales. Which of these two risks would more likely cause the enterprise’s shareholders to demand a higher return? Why?
8. When enterprise executives buy and sell stock based on private information they obtain as part of their jobs, they are engaged in insider trading.
a. Give an example of inside information that might be useful for buying or selling stock
b. Those who trade equities based on inside information usually earn very high rates of return. Does this fact violate the efficient markets hypothesis?
c. Insider trading is illegal. Why do you suppose that is?
9. Jamal has a utility function 𝑈(𝑊)=𝑊^(1⁄2), where W is his wealth in millions of dollars and U is the utility he obtains from that wealth. In the final stage of a game show, the host offers Jamal a choice between (A) $4 million for sure, or (B) a gamble that pays $1 million with probability 0.6 and $9 million with probability 0.4.
a. Graph Jamal’s utility function. Is he uncertainty averse? Explain
b. Does A or B offer Jamal a higher expected prize? Explain your reasoning with appropriate calculations. (Hint: The expected value of a random variable is the weighted average of the possible outcomes, where the probabilities are the weights.)
c. Does A or B offer Jamal a higher expected utility? Again, show your calculations
d. Should Jamal pick A or B? Why?
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