Question
Would risk-neutral people ever buy insurance that was not fair (that was biased against them)? Explain. (Hint: See Solved Problem 17.3.)
Step 1
A risk-neutral person is someone who is indifferent between a fair bet and certainty. This means that they do not have a preference for either risk or certainty, and their decisions are not influenced by the level of risk involved. Show more…
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Consider the example of grade insurance (see page 218 ). Suppose that with a grade-insurance policy, students would be compensated $\$ 5000$ a year for each point that their grade point average fell below the top grade (the resulting number might be an estimate of the impact of grades on future earnings). Explain why the presence of grade insurance would produce moral hazard and adverse selection. Why would moral hazard and adverse selection make insurance companies reluctant to sell grade insurance? Are you surprised that you cannot buy grade insurance?
How can moral hazard lead to more costly insurance premiums than one was expected?
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