a. When Sofia buys a computer for $1,000, she knows that there is a 10% chance that it will break within the first year if she treats it with care. She is risk averse and would therefore pay up to $120 for a warranty that will replace the computer if it breaks for any reason during this period. If a risk-neutral firm offered her a warranty at this price, what would its expected profits be if it sold her a warranty at this price? Assume that she treats the computer with care.

b. Explain how moral hazard might undermine the firm’s calculations.