Change in schedule plus extra credit problem set opportunity ...

I have done some editing of the course website that you should be aware of. I have decided to spend another class session (specifically, Tuesday, March 5) on the moral hazard/adverse selection topic. This means that Problem Set 6 will now be due on Thursday, March 7. Furthermore, the portfolio and capital market theory readings that were assigned for Tuesday, March 5, are now assigned for Thursday, March 7.

Prior to coming to class on Tuesday, I encourage all of you to try to solve the ?Extra Credit Moral Hazard Problem?. This problem examines how the design of an executive?s compensation contract can create incentives to either shirk or to work hard, so it provides a very compelling example of moral hazard in an important non-insurance context. At your option, you may turn your work on this problem in at the beginning of class on Tuesday, and the grade that you receive on it will replace your lowest problem set score (assuming that your extra credit score is higher). I plan to devote class time to working through the solution for this extra credit problem set. An easier way to solve questions 3-5 would be to use either Solver in Excel or Wolframalpha.com, although in principle the answers can also be solved by hand.

Also, a student asked the following questions about problem set 6 (which is now due next Thursday):

?I was having trouble thinking how to quantify the insurance company?s profit. My thought with full insurance (policy 1) was if the expected loss was $10,000 and the premium was $12,000, then on average they?re making a $2,000 profit. However, I don?t know how to think about this in terms of partial insurance (policy 2). Additionally for part (c), am I maximizing E(U(W)) under the assumption that the insured buys partial coverage and retrofits, while the insurance company turns a profit? I was wonder how I would set that up, but I guess I need to know how to calculate profit first.?

Here?s my response to these questions:

Regarding your questions, the insurer would make a $2,000 profit if the homeowner buys the policy and doesn?t retrofit. Buying the full coverage policy and not retrofitting is one of 4 possibilities; the others are 1) buy the full coverage policy and retrofit, 2) buy the partial coverage policy and don?t retrofit, and 3) buy the partial coverage policy and retrofit. Among these 4 choices, the homeowner will select the option which provides the highest expected utility. Therefore, to solve the problem you need to focus on figuring out which choice provides highest utility. Then you can answer whether the homeowner will retrofit the house, and what the insurer?s profit is. Obviously the insurer profit depends upon which policy is purchased and also whether the homeowner retrofits. In part C, you need to show that the option of not buying insurance but retrofitting provides the homeowner with the highest expected utility of all the possible decisions that the homeowner can make.

Finally, insurer profit is contingent upon whether or not the homeowner 1) buys insurance and 2) retrofits. Profit is equal to the difference between the premium paid and the expected value of claims paid by the insurer.

Extra Credit Moral Hazard Problem.pdf

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Source: http://fin4335.wordpress.com/2013/03/02/change-in-schedule-plus-extra-credit-problem-set-opportunity/

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