ACE 474 Final Exam QUESTIONS AND QUALITY ANSWERS 2026/27

How insurance premiums are set - CORRECT ANSWER Adverse Selection, moral hazard, stats discrimination Adverse Selection - CORRECT ANSWER Process by which the less desirable potential trading partners volunteer to exchange Moral Hazard - CORRECT ANSWER Incentives that lead people to behave in inefficient or even file ways (e.g., fraudulent claims or be negligent in their care of goods insured). Statistical Discrimination - CORRECT ANSWER Draw conclusions based on some known characteristics. Insurance premiums and credit scores. Effects of Information & Advertising on Consumption - CORRECT ANSWER The economics of information Signaling between potential adversaries -Costly-to-fake principle -Full disclosure principle Akerlof's lemons principle Adverse selection Statistical discrimination The costly-to-fake principle - CORRECT ANSWER It is the idea that to communicate information credibly to a potential rival, a signal must be costly or difficult to fake Warranties Million dollars worth advertising on national TV full disclosure principle - CORRECT ANSWER requires a company to provide the necessary information so that people who are accustomed to reading financial information can make informed decisions concerning the company Akerlof's Lemon's Principal: - CORRECT ANSWER It discusses information asymmetry, which occurs when the seller knows more about a product than the buyer. neoclassical model - CORRECT ANSWER The price of goods The quality of goods The amount of utility obtained from the good In reality, consumers do not have perfect information Why information is limited - CORRECT ANSWER Info varies in reliability. Costly to collect information. Limited ability to recall information. Efficient to use simple rules to process the information. Inability to process the information correctly. You will collect more information before making a purchase if.... - CORRECT ANSWER Marginal benefit of information greater than Marginal cost of obtaining and interpreting the information Search goods - CORRECT ANSWER Quality can be determined by inspection before purchase. Experience goods - CORRECT ANSWER Quality can be determined by consuming good (brand). Credence goods - CORRECT ANSWER Quality cannot be determined even after good is consumed (regulation, investigation, certification). Asymmetric Information - CORRECT ANSWER One party to a transaction has more information than the other party. Believable information has two properties: - CORRECT ANSWER It is costly to fake (signal is difficult to fake). It induces full disclosure. Stats discrimination - CORRECT ANSWER Information is costly to obtain about a characteristic for an individual, so look at how common the characteristic is in the individual's group. Examples: SAT/ACT scores Undergraduates to graduates Safe, young male drivers Sports cars vs. minivans Red cars - more reckless Wage discrimination Voluntary food labeling: 3 big limitations - CORRECT ANSWER Presence of undesirable characteristics Relative information Partial disclosure and innuendo Third-party labeling can increase reliability and credibility by - CORRECT ANSWER Setting consistent standards Verifying producer claims Certifying products Enforcing quality claims Conventional utility function - CORRECT ANSWER People care about whether events increase or decrease their total wealth. Kahneman & Tversky value function - CORRECT ANSWER People care about individual gains and losses. Function is much steeper in losses than in gains. Losses given much heavier weight in decisions than gains. People evaluate events first and then add the separate values together. Diminishing returns in gains and losses. Hedonic Framing - CORRECT ANSWER To make people happier about their alternatives: Segregate gains Combine losses Offset small loss with larger gains Segregate small gain from large loss Hedonic framing (cont.) - CORRECT ANSWER Offset a small loss with a larger gain Back to grandma and the speeding ticket Segregate small gains from large losses "Silver lining effect" Heuristics - CORRECT ANSWER The process by which people find things out for themselves, usually by trial and error, leading to the development of rules of thumb. This process often leads to other errors. These errors can be systematic. People use "rules of thumb" (often erroneous) in decision-making: - CORRECT ANSWER Availability bias Representativeness bias Anchoring and adjustment bias