Question: Problem 2: Moral Hazard (25 points). Kennedy has some non-wage income $30,000 and a dangerous job that pays $60,000. If Kennedy chooses a high level

Problem 2: Moral Hazard (25 points). Kennedy has some non-wage income $30,000 and a dangerous job that pays $60,000. If Kennedy chooses a high level caution, she will get injured with probability p = 0.1. If Kennedy chooses a low level of caution, she will get injured with probability p = 0.5. If she gets injured, she can no longer work. Low caution is costless, but high caution costs Kennedy $10,000. Kennedy's expected utility follows EU = (1 p) p Cg + p p Cb where Cg represents Kennedy's consumption if she does not get injured and Cb represents Kennedy's consumption if she gets injured. a) Suppose there is no insurance. What is Kennedy's expected utility from choosing low caution? What about from choosing high caution? Will Kennedy choose low or high caution? 1 b) Suppose that the government provides workers' compensation, so that Kennedy gets $40,000 if she gets injured and can't work. Will Kennedy choose low or high caution now?

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