4. Two questions about information economics: a) In this question we'll figure out whether a warranty can be a credible signal of hidden quality. Say that a refurbished cell phone that was known to be good would sell for $600, while one that was known to be bad would sell for $400. The problem is that while the seller knows the true quality of the phone, the buyer does not. Say that the seller could offer a (legally binding) warranty. The expected cost of honoring the warranty would be $kg for a good phone and $kB for a bad phone. For what values of kg and kB can a warranty be a credible signal of the quality of a phone here? (Please show your work.) Explain your answer. In general, what makes a signal credible? b) Say that there is an insurer with potential customers that are either high, medium, or low risk. 5% of people are high risk types with an estimated average loss of $20,000 each. 30% of people are medium risk types with an estimated average loss of $3,000 each. The remaining proportion are low risk types with an expected loss of $500 each. What would be the actuarially fair price for insurance in this group? What would it mean for the insurer to face an 'adverse selection' of customers at some price? What factors might determine if they face such a problem or not?
4. Two questions about information economics: a) In this question we'll figure out whether a warranty can be a credible signal of hidden quality. Say that a refurbished cell phone that was known to be good would sell for $600, while one that was known to be bad would sell for $400. The problem is that while the seller knows the true quality of the phone, the buyer does not. Say that the seller could offer a (legally binding) warranty. The expected cost of honoring the warranty would be $kg for a good phone and $kB for a bad phone. For what values of kg and kB can a warranty be a credible signal of the quality of a phone here? (Please show your work.) Explain your answer. In general, what makes a signal credible? b) Say that there is an insurer with potential customers that are either high, medium, or low risk. 5% of people are high risk types with an estimated average loss of $20,000 each. 30% of people are medium risk types with an estimated average loss of $3,000 each. The remaining proportion are low risk types with an expected loss of $500 each. What would be the actuarially fair price for insurance in this group? What would it mean for the insurer to face an 'adverse selection' of customers at some price? What factors might determine if they face such a problem or not?
Chapter1: Making Economics Decisions
Section: Chapter Questions
Problem 1QTC
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Transcribed Image Text:4. Two questions about information economics:
a) In this question we'll figure out whether a warranty can be a credible signal of hidden
quality. Say that a refurbished cell phone that was known to be good would sell for
$600, while one that was known to be bad would sell for $400. The problem is that
while the seller knows the true quality of the phone, the buyer does not.
Say that the seller could offer a (legally binding) warranty. The expected cost of
honoring the warranty would be $kg for a good phone and $kg for a bad phone. For
what values of kg and kB can a warranty be a credible signal of the quality of a phone
here? (Please show your work.)
Explain your answer. In general, what makes a signal credible?
b) Say that there is an insurer with potential customers that are either high, medium, or
low risk. 5% of people are high risk types with an estimated average loss of $20,000
each. 30% of people are medium risk types with an estimated average loss of $3,000
each. The remaining proportion are low risk types with an expected loss of $500 each.
What would be the actuarially fair price for insurance in this group? What would it
mean for the insurer to face an 'adverse selection' of customers at some price? What
factors might determine if they face such a problem or not?
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