TRUE OR FALSE
1
LAST NAM E: _____________________ FIRST NAME: ____________________________
STUDENT ID: ____________________
Write your name on this sheet and hand it in with your bluebook. Make sure you write the question number and
your answers in your bluebook.
ARE/ECN 115A FALL 2016
Final Exam
Please answer ALL questions. Note that the exam has 4 pages and is printed on both sides of the page.
Part I: True or False. Please write down the question number and write out the words “TRUE” or “FALSE”.
exams.
1. A lender who is unable to distinguish between bo
owers that have a very risky project from those who have
a safe project faces an adverse selection problem.
2. The more mobile is an asset, the more willing a lender will be to accept it as collateral.
3. The IBLI index insurance contract presented in the video during discussion section was designed to protect
poor maize farmers in Northern Kenya against drought risk.
4. If an individual is risk loving, her certainty equivalent associated with a profitable but risky activity will be
negative.
5. Informal risk sharing a
angements are more effective at managing idiosyncratic risk than covariate risk.
6. A key feature of group-based lending in micro-finance is that the lender assigns bo
owers to each group.
7. Selection bias will be positive if: ?(?0?|?? = 0) < ?(?0?|?? = 1).
8. By increasing the interest rate, it is possible that a lender facing moral hazard may reduce his own expected
profit.
9. Since agricultural households that produce rice typically consume part of what they produce, they reduce
their rice consumption when the price of rice increases.
10. Uninsured risk imposes an ex ante burden on farmers when they decide not to make profitable investments
ecause they are unwilling to bear the risk entailed in the investment.
11. As markets become more integrated it is generally easier for monopolies to emerge.
3
13. Risk, Activity Choice and Insurance. Charline must decide whether to open a business or work as an
economics tutor. The business she is considering is to open a store called “Charline Sells Seashells by the
Seashore”. This business is risky because 60% of the time Charline would have a GOOD seashell harvest
and earn an income of $300. But 40% of the time Charline would have a BAD seashell harvest and earn an
income of $0. If she instead chooses to work as an economics tutor, Charline would earn a certain income
of $160. Charline has initial wealth of $100 and her utility function is: ?(?) = √?, where C is
consumption.
.
a. What is Charline’s expected income if she opens her business?
. What is Charline’s expected utility if she opens her business? (Don’t forget her initial wealth!)
c. What is Charline’s certainty equivalent associated with opening her business?
d. What is Charline’s risk premium associated with opening her business?
e. Is Charline risk neutral, risk averse or risk loving?
f. Which activity will Charline choose? (Open a business or Economics tutor)
Now assume that an insurance agent offers Charline an index insurance contract which is based on
temperature (in general, seashell harvest is worse when temperatures are low). The insurance premium is
$40. There are two possible values of temperature, LOW and HIGH. When temperature is LOW, the
insurance company makes a payout of $100 to Charline. When temperature is HIGH, the insurance
company doesn’t pay Charline anything. Like most index insurance contracts, this one is not perfect.
Sometimes Charline would have a BAD seashell harvest even though temperature is HIGH and sometimes
she would have a GOOD seashell harvest even though temperature is LOW. So there are four possible
outcomes for Charline if she insures her business. Their probabilities are as follows:
Pr(LOW temperature and BAD harvest) = .30;
Pr(LOW temperature and GOOD harvest) = .10;
Pr(HIGH temperature and BAD harvest) = .10;
Pr(HIGH temperature and GOOD harvest) = .50.
g. What is Charline’s expected utility if she buys the insurance and opens the business?
h. Which activity will Charline choose? (Open business without insurance, Open business with
insurance, Economics tutor).
4
13. Asymmetric Information and the Credit Market. Sean is a rice farmer. To grow rice, he must buy
seeds, which cost $100. Rice production is risky. If he gets a GOOD harvest, Sean earns revenues of
$500. If, instead, he has a BAD harvest his revenues are $0. After Sean plants the seeds, he must decide to
either WORK HARD or BE LAZY. If he chooses to WORK HARD, he will have a GOOD harvest with
80% probability. If he chooses to BE LAZY, he only has a 20% probability of having a GOOD harvest.
For parts (a) – (e) assume that Sean has $100 in wealth, so he can buy the seeds and plant rice without a
loan.
a. What is the expected value of Sean’s consumption if he chooses to WORK HARD?
. What is the expected value of Sean’s consumption if he chooses to BE LAZY?
Now let’s be more realistic about the cost of working hard. Specifically, for all remaining parts of this
problem assume Sean’s utility function is:
If he chooses to WORK HARD: U(C) = C - 240;
If he chooses to BE LAZY: U(C) = C.
In other words, if Sean chooses to BE LAZY, his utility is exactly equal to his consumption. If he chooses
to WORK HARD, his utility is equal to his consumption minus the “cost” of hard work, which is 240.
c. What is the value of Sean’s expected utility if he chooses to WORK HARD?
d. What is the value of Sean’s expected utility if he chooses to BE LAZY?
e. Will Sean choose to WORK HARD or BE LAZY?
For parts f – j, assume that Sean does not have $100 to buy the rice seeds, and thus he needs a $100 loan.
Assume that the credit market is characterized by perfect competition and that lender’s opportunity cost of
lending is zero. (In other words, the interest rate the lender could have earned if he did not make the loan is
zero). Finally, assume that the loan contract is limited liability so that Sean repays the loan plus interest if
he has a GOOD harvest but repays nothing if he has a BAD harvest.
f. What is the maximum interest rate Sean would be willing to pay if he chooses to WORK HARD?
g. What is the maximum interest rate Sean would be willing to pay if he chooses to BE LAZY.
h. Under symmetric information (as in parts f and g) a loan contract specifies two terms:
ate, bo
ower’s effort level>. In a world of symmetric information and perfect competition, what
would the terms of the equili
ium loan contract be?
For parts i and j, assume we are in a world of asymmetric information in which the bank cannot observe
the effort level the bo
ower chooses, and thus the equili
ium contract can only specify the interest rate.
Continue to assume perfect competition.
i. What type of asymmetric information problem does the bank face?
j. What is the equili
ium interest rate charged by lenders?
5
2. Robers Pie
e is a Haitian rice farmer. His household consumes rice (XR) and other stuff (Xo) and have a
total income of Y.
a. Use names (large boxes) or notation to label the following graph to illustrate optimal consumption of
these two goods. Assume rice is on the horizontal axis.
. The price of rice increases 50% due to a trade war with neighboring country. On the less cluttered
graph below, draw how this price change affects optimal consumption. Assume the Net Benefit
Ratio (NBR) for Robers Pie
e’s household is positive. On your modified graph, indicate which
change is due to the fact that this household produces rice.
c. Explain
iefly how this graph would change if the NBR for the household was negative.
TRUE OR FALSE
1
LAST NAM E: _____________________ FIRST NAME: ____________________________
STUDENT ID: ____________________
Write your name on this sheet and hand it in with your bluebook. Make sure you write the question number and
your answers in your bluebook.
ARE/ECN 115A FALL 2016
ANSWER KEY: Final Exam
Please answer ALL questions. Note that the exam has 4 pages and is printed on both sides of the page.
Part I: True or False. Please write down the question number and write out the words “TRUE” or “FALSE”.
exams.
1. A lender who is unable to distinguish between bo
owers that have a very risky project from those who have
a safe project faces an adverse selection problem. TRUE
2. The more mobile is an asset, the more willing a lender will be to accept it as collateral. FALSE. This
makes it more difficult for the lender to collect the collateral.
3. The IBLI index insurance contract presented in the video during discussion section was designed to protect
poor maize farmers in Northern Kenya against drought risk. FALSE. The insurance was designed to
protect HERDERS.
4. If an individual is risk loving, her certainty equivalent associated with a profitable but risky activity will be
negative. FALSE. The certainty equivalent will be positive. The risk premium will be negative.
5. Informal risk sharing a
angements are more effective at managing idiosyncratic risk than covariate risk.
TRUE
6. A key feature of group-based lending in micro-finance is that the lender assigns bo
owers to each group.
FALSE. Bo
owers should self-select into micro-finance groups.
7. Selection bias will be positive if: ?(?0?|?? = 0) < ?(?0?|?? = 1). TRUE. Selection bias is equal to
?[???|?? = ?] − ?[???|?? = ?]. ?? ?? ?(???|?? = ?) < ?(???|?? = ?) selection bias will be positive.
8