SAMPLE EXAM 2

Exam is closed book. The points add up to 100. Good luck!

1. (10 points) Define Adverse Selection and Moral Hazard. How are they differ-
ent? Give examples of economic situations which suffer from adverse selection
and moral hazard.

2. (10 points) What is risk aversion? Give definition in words and provide a con-
dition on utility function that defines it.

3. (10 points) Give an example of a commitment device. What is credible and

incredible threat?

4. (10 points) Find Nash Equilibria of the following game:

A B C
N 3,2 2,1 1,5
W 1,4 5,2 1,3
S 4,5 3,3 2,4
E 1,4 1,5 5,0

5. The economy consists of two firms called 1 and 2 and two goods called G1 and
G2 . Firm i (i = 1, 2) produces only good Gi . The goods are substitutes, so the
inverse demands for goods G1 and G2 are given by

P1 (q1 , q2 ) = a − q1 − kq2
P2 (q1 , q2 ) = a − q2 − kq1

where q1 and q2 are the amounts of goods G1 and G2 produced by firms 1 and 2
and 1 ≤ k < 1.1 is a constant. The marginal costs for both firms are c. Firm i’s
(i = 1, 2) profit is therefore Pi (q1 , q2 )qi − cqi .

a) (10 points) Suppose that firms simultaneously choose quantities. Find a

Nash Equilibrium.
b) (10 points) Now suppose that first firm 1 chooses its quantity, then firm
2 observes the choice of firm 1 and also chooses quantity. Use backward
induction to find equilibrium outcome (if you get a messy formula with
parameters a, k and c do not spend time simplifying, leave it as is).

1
6. Consider Centipede Game (players are 1 and 2, the top payoff is of player 1, the
bottom - of player 2):

1 B 2 D 1 F 2 H 1 J 2 L
6
A C E G I K 6

5 2 6 3 7 4
0 5 2 6 3 8

a) (10 points) Find equilibrium outcome using backward induction. State

equilibrium strategies for both players.
b) (10 points) Suppose centipede game is repeated infinitely many times. For
which discounting factor δ can the outcome (6, 6) be sustained as equilib-
rium payoff in each period? Find Nash equilibrium of the repeated game
that does it and prove that it is indeed an equilibrium (Hint: make sure
your δ works for both players).

7. Consider health insurance company and a person (say, Bob) who wants to be
insured. Bob gets salary wh if he is healthy. If he gets sick he has to pay medical
expenses, so after that he is left with ws (wh > ws ). Bob is risk averse, his utility
√
of money is U ( x ) = x. Also, Bob gets sick with probability π and insurance
company knows that. Suppose insurance company proposes Bob to pay some
amount p for insurance and in return it guarantees to fully insure Bob in case of
sickness.

a) (5 points) What does it mean for Bob to be fully insured? Give a definition.
b) (5 points) What is the maximal price p that Bob is willing to pay to the
insurance company for full insurance? Provide a formula, do not simplify,
leave it as is.
c) (5 points) What is the smallest price p that insurance company is willing
to accept? Provide a formula, do not simplify, leave it as is.
d) (5 points) Suppose insurance company is not sure what are the chances of
Bob getting sick. Insurance company thinks that π = π1 with probability
γ and π = π2 , where π1 > π2 , with probability 1 − γ. What is the smallest
price insurance company is willing to accept in this case?