Question: ? 0 Consider a simple example of moral hazard. Suppose that Chester goes into a casino to make one bet a day. The casino is

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Consider a simple example of moral hazard. Suppose that Chester goes into a casino to make one bet a day. The casino is very basic; it has two bets: a safe bet and a risky bet. In the safe bet, a nickel is flipped. If the nickel lands on heads, Chester wins

100 .

If it lands on tails, Chester loses $

100 .

The risky bet is similar: a silver dollar is flipped. If the silver dollar lands on heads, Chester wins $

5, 000 .

If it lands on tails, Chester loses $

10, 000 .

Each coin has a

50 %

chance of landing on each side.

What is the expected value of the safe bet?

safe bet: $

What is the expected value of the risky bet?

risky bet: $

Now suppose that an insurance company opens outside of the casino. They notice that Chester, like everyone else, always leaves the casino having played the safe bet, so they offer to sell Chester insurance for $

50

that, if he loses, covers his losses. If Chester wins, he does not have to pay anything extra, having already paid the $

50 .

Note that as long as Chesfer does not change his behavior, the insurance company makes $

0

in expectation.

Once Chester buys the insurance, what are his expected winnings from the safe bet? Ignore the cost of the insurance.

safe bet: $

Once Chester buys the insurance, what are his expected winnings from the risky bet? Ignore the cost of insurance.

risky bet: $

?0 Consider a simple example of moral hazard. Suppose that Chester

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