Louisa is an avid cyclist who is currently working on her business degree. She normally rides an $ 800 bike to class. If Louisa locks her bike carefully—locks both wheels—the chance of theft for the term is 5%, but this careful locking procedure is time consuming. If she is less careful—just quickly locks the frame to a bike rack—the chance of theft is 20%. Louisa is risk averse and is considering buying theft insurance for her bike. Louisa may purchase one of two types of insurance. With full insurance, Louisa pays the premium and gets the full, $ 800 value of the bike if it is stolen. Alternatively, with partial insurance, Louisa receives only 75% of the bike’s value, $ 600, if the bike is stolen. Which contract is more likely to induce moral hazard problems? To break even on consumers like Louisa, what price would the risk-neutral insurance company have to charge for full insurance? If we observe Louisa buying partial insurance, what can we say about the trade-off between moral hazard and efficient risk bearing?
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