Question

1. A life insurance company must be concerned about the possibility that the people who buy life insurance may tend to be less healthy than those who do not. This is an example of adverse selection. True, False, or Uncertain? Support your answer with an explanation (one to two sentences) or a diagram. [2 marks] 2. An insurance company must be concerned about the possibility that someone will buy fire insurance on a building and then set fire to it. This is an example of moral hazard. True, False, or Uncertain? Support your answer with an explanation (one to two sentences) or a diagram. [2 marks] 3. Consumers aim for consumption smoothing because of diminishing marginal utility. True, False, or Uncertain? Support your answer with an explanation (one to two sentences) or a diagram. [2 marks] 4. If government intervenes in the market for health insurance in order to address the adverse selection problem, everyone will be better off as a result. [2 marks]

Answer 1

1. True

This is because in case of insurance companies, while buying premiums, people tend to disclose incomplete information in order to avoid paying high premium charges, which gives rise to the problem of adverse selection

2. True

Moral Hazard refers to the change in risk attitude of the people once they buy the insurance, since they believe any cost of damage would be borne by the insurance company

This given situation represents moral hazard

3. False

This is because people engage in consumption smoothing in order to spread their consumption spending well across their income levels. Diminishing MU states how additional utility derived from additional consumption falls as consumption increases. The two concepts are not related

4. Uncertain

This is not certain. It can either work for good or bad.