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ECO 6115 – Why do people want to fully insure even

ECO 6115: Additional Example Questions for Test 1. Why do people want to fully insure even in cases when the premium exceeds the expected loss? 2. Why do insurance companies behave as if risk-neutral, even if their owners, managers and employees are risk-averse? 3. Explain why risk-averse investors might want the corporations in which they invest to make risk-neutral decisions. 4. As an executive for the International House of Grits, you are responsible for recommending whether or not to expand the small chain of breakfast restaurants. You estimate that a successful expansion would net IHoG $12 million in profits, whereas an unsuccessful expansion would bring a $3 million loss. You estimate a 25% probability of success from the expansion. You also have the option to purchase market research about demand for grits before making your decision. If the research is indicates a good demand outlook for grits, your estimate of the probability of success would increase to 40%. But if the research looks indicates a poor demand outlook for grits, your estimate of probability of success would fall to 10%. You think there is a 50/50 chance the research could point either way. I Ho G makes decisions based on risk-neutrality. a. Without the market research, what is the expected value of the expansion? What do you recommend? b. If the research indicates the demand outlook is good, what is the expected value of the expansion? c. If the research indicates the demand outlook is bad, what is the expected value of the expansion? d. If you purchase the research, what is the expected value of the expansion? e. What is the expected value of the information provided by the research? f. The research costs $0.5 million. Do you buy it? 6. Is it generally in the best interest of shareholders for management to insure that there is absolutely no shirking in the workplace? Why or why not? 7. Discuss the major methods for input procurement, major sources of transactions costs affecting these methods, and general guidance for choosing optimal methods for acquiring inputs. 8.Harry Homeowner wants Angela Agent to sell his house for him. The price he will get for his house depends partly on Angelas effort,e and partly on luck,l: P = f(e,l). The opportunity cost of Angelas effort is c per unit of effort. Harrydoes not know how to determine Angelas effort.Harry has only one house to sell whereas Angela is the selling agent for many houses. For each type of contract below, answer the following questions: a.Write equations that describe the amount earned by Harry and by Angela. b.Who is/are the residual claimant(s)? c.Why is/is not the contract productively efficient? d.Who bears the risk? Under what circumstances is the risk-bearing efficient? The types of contracts to consider are: 1.Harry pays a fixed fee F to Angela and keeps any proceeds from the sale less the fixed fee.2.Angela pays a fixed fee F for the right to sell the house, but she keeps any proceeds from the sale less the fixed fee.  3.Harry pays Angela by the hour (suppose effort is measured in hours of work) and keeps any proceedsfrom the sale. The wage isw. 4.Angela receives 10% of the sales price and Harry receives 90%.

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