Multiple Choice Questions
1. An insurance company offers doctors malpractice insurance. Assume that malpractice claims against careful doctors cost $5,000 on average over the term of the policy and settling malpractice claims against reckless doctors costs $30,000. Doctors know whether they are reckless or careful, but the insurance company only knows that 10% of doctors are reckless. How much do insurance companies have to charge for malpractice insurance to break even?
a. $5,000
b. $7,500
c. $27,500
d. $30,000

2. An employer faces two types of employees.
Regular workers are 70% of the population and generate $100,000 in productivity.
Exceptional workers are 30% of the population, and generate $120,000 in productivity.
Employees know their types, and reject salaries below their productivity. If the employer offers a salary equal to the average productivity in the population, what will be the employer's per-employee profit?
a. -$10,000
b. -$6,000
c. $0
d. $4,000

3. An all-you-can-eat buffet attracts two types of customers. Regular customers value the buffet at $20 and eat $5 of food in costs to the restaurant. Hungry customers value the buffet at $40 and eat $10 of food. If there are 100 of each type in the market for a buffet dinner, what is the restaurant's profit?
a. $2,500
b. $3,000
c. $4,500
d. $6,500

4. To combat the problem of adverse selection, informed parties can employ techniques.
a. More; signaling
b. Less; signaling
c. Equally; screening
d. Equally; signaling

5. Which of the following can be an example of a signal?
a. An air-conditioning manufacturer offers a 50-year warranty.
b. A lawyer offers to be paid only if the client wins.
c. A student pursues an MBA.
d. All of the above

6. Which of the following is not an example of adverse selection?
a. A business bets the proceeds of a bank loan on the next NFL game.
b. An accident-prone driver buys auto insurance.
c. A patient suffering from a terminal disease buys life insurance.
d. A really hungry person decides to go to the all-you-can-eat buffet for dinner.

7. The demand for insurance arises primarily from people who are
a. Risk-seeking.
b. Risk-averse.
c. Risk-neutral.
d. None of the above

8. Which of the following is a potential solution to the adverse selection problem faced by insurance companies?
a. Offer plans with different deductibles so that higher-risk customers accept higher deductibles.
b. Create a national database of customers that allows companies to look up each person's historical risk.
c. Mandate that every person purchase insurance.
d. All of the above

9. An insurance company suffers from adverse selection if
a. Safe customers are less likely to insure than risky customers.
b. Customers know their willingness to pay for insurance but the company does not.
c. A customer takes on much greater risk because he is insured.
d. Its customers are risk averse.

10. Which of the following is an example of adverse selection?
a. A safe driver taking greater risk in a rental car than his own car.
b. A terminally ill person purchasing life insurance.
c. An employment contract encourages little effort on the part of employees.
d. All of the above