EC421 – Advanced Microeconomics

Tutorial 1

True/False Questions: Provide a brief explanation for your answer.

1. In the model of insurance and uncertainty discussed during lectures, an individual exhibits
declining marginal utility of income if and only if she is risk averse.

True. Risk averse preferences are defined by a utility function with U’’(w) < 0, e.g
U(w)=w^1/2. This is graphically represented as a concave preference curve in our
model, with utility(w) on y-axis, and wealth on x-axis, implying diminishing MU and so
by Jensen EV < UEV; a guaranteed monetary payment is strictly preferred to a lottery
of same expected value.

Risk-loving and risk-neutral individuals, U’’(x) >0 (convex), U’’(x)=0 (linear),

respectively, showing increasing MU(w) and constant MU(w). Neither display
diminishing marginal U(w).

Graphically below illustrates the concavity of risk averse preferences.

2. A health insurance contract with a premium of r = £200, a pay-out q = £800 offers partial
and fair insurance if IH = £1,500, IS = £0, and the probability of illness p = 0.2.

False – the contract is partial, but not fair.

Actuarially fair contracts require r=p*q; on average nor insurer or insured should lose
money in a contract. This contract is actuarially unfair as 200 > 800*0.2 = 160. The
actuarially fair premium would require r*=160 or p*= 200/800 = 0.25.

Full insurance requires consumption to be equal in both good (healthy) and averse
(sick) states: IH-r=Is-r+q

In this, 1300 > 600, representing partial insurance.

Therefore, the contract is partial and unfair. The insurance company will make positive
profits and consumer will leave more in good times then bad; the market is not perfectly
competitive (at the level of insurers and buyers)
3. Suppose you have a job paying £50,000 per year. There is a five percent probability that
your wage is reduced to £20,000 next year. Assuming you could insure yourself against the
risk of reduced income next year, the actuarially fair insurance premium would equal £1,000.

False. The actuarially fair premium would = £1,500.

Actuarially fair insurance requires that the premium (r) = the product of probability (p)
and cost (q) of an adverse event. 5%*30,000 = 1,500  r. Fair pricing breaks even in
expectation – premium exactly equals probability-weighted loss.

Thus, r = 1,000 is not fair. On average, the insurer would lose money on this contract –
it is unfair.

If priced a r=£1,000, fair insurance would require p* = 0.03

4. Insurance represents a transfer of wealth from healthy states to sick states.

True. With insurance, individuals give up income in healthy state to sick-state (IH-r=IS-
r+q); a transfer from healthy to sick.

Risk averse individuals (U’’(W)<0) aim to maximize expected utility by consumption

smoothing between states (healthy -> sick) due to their diminishing MU(W).

Because of said diminishing MU(W) and concavity, receiving additional wealth in a

good state commands a lesser change in MU(W) than a equal loss of wealth in the
averse (sick) state; meaning it is rational for a risk-averse individual to give up wealth
in healthy state to a sick state. A pound when sick/poor is worth more than a pound
when healthy/rich

This is called consumption smoothing.

Short Answer Questions:

5. Discuss how the concepts of issues related to asymmetric information can be applied to
financial markets.

Asymmetric information is a situation whereby not all parties in an exchange are privy
to the same information, which can lead to inefficient outcomes, arising from adverse
selection (ex-ante, pre-contract) and (ex-post, post-contract) moral hazard.

Adverse selection is a pre-contract private information issue arising from asymmetric

(private) information in a market. Companies know more about their fundamentals
than investors. Under this private information, types or quality are hidden so lower-
quality issuers are more likely to sell. This presence of poor-quality stocks in the market
leads buyers to price to the average, so higher-quality issuers withdraw. Consequently,
the average is skewed away from the efficient outcome. As per Akerlof’s (1970) “lemons
mechanism”, this exit of higher-quality issuers further skews the pool towards lower-
quality companies, pushing down prices and further driving out good types. This is the
adverse selection death spiral.

Issues may also arrive post-contract. This is called ‘moral hazard’, opportunistic
behaviour by a contracted agent which can not be perfectly observed. An example of
this in financial markets could be ‘Too Big to Fail’ and misuse of funds, especially
prevalent during the 2008 GFC, where large banks took on high-risk investments, as
they did not bear the full risk of these securities.

Events like the 2008 GFC shows these issues are present in financial markets, and
generate inefficiency even in sophisticated markets.

Remedies: disclosure, auditing, ratings, and regulation (e.g., the SEC’s oversight) raise
information quality and monitoring, reducing adverse selection and moral hazard.
Intuition: when quality or actions can’t be seen, markets either underprice good issuers
or overpay for risky behaviour—information and monitoring move prices and
behaviour closer to the efficient outcome.
6. In the paper “Asymmetric Information, Adverse Selection and Online Disclosure: The
Case of eBay Motors” from the suggested readings, Gregory Lewis (2011) discusses adverse
selection in online markets.
a) Why might adverse selection occur in the first place in online markets?

b) Discuss two possible (policy) solutions that might limit the negative effects that occur
because of adverse selection in online markets?

In online markets, platforms can reduce adverse selection by acting on both sides.
Platform screening (buyer-side tools): enforce money-back guarantees, escrow/payment
conditional on item matching the listing, and require third-party certificates; these raise
the expected cost of misreporting and pay only for verified quality.

Seller signalling: verified sellers can credibly disclose diagnostics, provide warranties,
or accept return policies—costly for lemons, credible for high-quality items. Together,
these tools explain why adverse selection can be limited on platforms like eBay Motors:
disclosure + transparency mechanisms work.

c) What are the authors’ conclusions regarding the presence of adverse selection in the
online car market? What is the authors’ explanation for this?
7. You are faced with two job opportunities. The actual monthly salary is uncertain, but you
have the following information:

- Job 1: 40% chance of £2,500, 60% of £1,600

- Job 2: 25% chance of $5,000, 75% of £1,000

a) Which job is preferred if you have the following utility functions, where x represents
monthly salary? Show your work.

i) U(x) = x1/2

ii) U(x) = x2

b) Using the concept of expected value (in this case expected income), discuss why parts of
your answer to part a) appear strange. In your answer, explain the reasoning for this.

In part a, the fact that individual prefers Job 1, which has a lower expected value than
Job 2 is not a contradiction. Risk-averse individuals rank uncertain choices by the
expected utility they will derive from a given payoff, considering their risk-payoff
preference as per Jensen: E[U(W)]<U(E[W]. They are not strictly payoff maximising as
a risk-neutral (U’’(x)=0) would be. Risk averse individuals (U’’(x)<0) strictly prefer a
guaranteed payoff, as opposed to a lottery with the same EV. clearly evident in this
example.
8. Moe, Larry and Joe each have £12 to spend on beer in a bar. Their utility functions are U
(BM) = √ B M, U (BL) = BL, and U (BJ) = (BJ)2, respectively, where B denotes the consumption
of beer bottles in the bar. The price of a bottle of beer is £3. Unfortunately, the only bar is in a
dangerous part of town and there is a 50% chance that they will get mugged on their way to
the bar. If that happens, they lose their entire bar money.

Use the information above to answer the following questions.

a) Find the expected value for each of them (here: expected consumption of beer bottles).

b) Find the expected utility of consuming beer for each of them.

c) Now assume that they can each buy “protection” from the neighbourhood bad guy at £6.
each. If they buy this protection, they will not get mugged. Which of the friends will buy the
protection?

d) Discuss the findings from part c) in the light of our lecture content.
[Hint: For a good answer, try to include the terms risk attitudes, asymmetric information, and
insurance in your response.

9. Malcom’s preferences over wealth can be described by the utility function U(x) = √ x .
Suppose that his entire wealth is provided by a property worth £1 million. However, this
property has a 10% chance of being completely destroyed by a fire.
(a) Compute the expected utility of the property for Malcom.

(b) Suppose that a fire insurance contract is available that offers full coverage for Malcom’s
property in case of accident. For each of the following two scenarios, determine whether
Malcom will buy insurance and explain your answer:
i. the price of insurance is £200,000?

ii. the price of insurance is £150,000?

(c) What is the Certainty Equivalent for Malcom? Based on your answer, up to how much
would Malcom be willing to spend on the insurance contract? Explain your response.
10. All entry-level accountants in Glasgow either have high or low abilities. All potential
employers value a high-ability worker at £8,000 per month and a low-ability worker at
£4,000. The supply of high-ability workers is QS (High) = 0.05 (W - 2,000) and the supply for
low-ability workers is QS (Low) = 0.1 (W - 2,000), where W is the monthly wage.

Use the information above to answer the following questions:

a) If employers are not able to observe the workers’ abilities and employers assume that 1/4
of the entry accountants are high-quality, what is the equilibrium wage? How many
workers of each type do employers hire? Show your work.

b) Now let’s assume that employers are able to observe the workers’ abilities. What are the
equilibrium wages in this case? How many workers of each type do employers hire?
Show your work.

c) Using your answers to parts a) and b), comment on the role of asymmetric information in
the labour market. In your answer, discuss possible solutions to the issue at hand.