Question:

i) The manager of Top Rock Company is introducing a new product that will yield $200 millions in profits if the economy does not go into recession. However, if a recession occurs, demand for the good will fall sharply so that the company will lose $500 millions. If it is projected that there is a 20% chance the economy will go into recession, what are the expected profits to Top Rock Company of introducing the new product?

ii) Do you think a risk averse individual will always take insurance when faced with risky prospects while a risk loving individual will always prefer the risky prospects? Explain your answer.

iii) Distinguish between moral hazard and adverse selection.

iv) A company wishes to launch a new quality product at a high price and realizes that the market is filled with bad quality of similar product at relatively low prices. Consumers are not able to distinguish between the good and bad quality products. Explain clearly how such situation will affect the sales of the new product.

v) What are the solutions to prevent adverse selection?