Microeconomics Chapter 10

participation mandates prevent markets from

failing because of adverse selection

2 ways the government can solve information asymmetries (adverse selection & moral hazard)

1. Give or require information for the less informed party 2. mandate participation in a market

2 ways the government can intervene

1. provide missing information to the less-informed party, or require the more-informed party to reveal it 2. mandate participation in a market or program, mandates prevent markets from failing because of adverse selection

3. Consider a market for health insurance with 1,000 potential buyers. The insurance company knows that half of the potential buyers are of poor health and will cost the insurance company $50,000 annually, while the other half are of good health and will cost the insurance company $10,000 annually. However, the insurance company does not know which individual people are of poor health or good health. The potential buyers know whether they are of poor health or good health. If the insurance company sets the price of the insurance policy at $30,000, _____ people will purchase insurance, and the average per-person cost incurred by the insurance company will be _____. Multiple Choice 1,000; $30,000 500; $40,000 1,000; $10,000 500; $50,000

500; $500,000

Moral hazards are about the

ACTIONS and occurs AFTER the parties have voluntarily entered into an agreement

Moral hazards is about

Actions and occurs AFTER the parties have voluntarily entered into an agreement

Which of the following situations is likely to involve moral hazard? A course is a requirement for physics majors but an elective for biology majors. After receiving an emergency call during class, a professor leaves students unsupervised for the rest of the period. A course has a reputation for being an easy A, even though after the term begins, students realize that it isn't.

After receiving an emergency call during class, a professor leaves students unsupervised for the rest of the period.

Some policy makers have suggested that mandatory health insurance coverage would: Multiple Choice · help reduce the cost of health care. · overcome adverse selection in the market for health insurance. · keep premiums lower than they would be if healthy people could opt out of insurance. · All of these are true.

All of these are true

The used car market: Multiple Choice exemplifies the "lemons" problem. displays asymmetric information. is subject to the problem of adverse selection. All of these are true.

All of these are true

Asymmetric information in a transaction can result in: Multiple Choice moral hazard. adverse selection. a lemons problem. All of these can result from asymmetric information.

All of these can result from asymmetric information

Moral hazard can be avoided by: Multiple Choice employers monitoring employee effort. removing the asymmetric information. employers incentivizing employees to maintain consistent effort. All of these statements are true.

All of these statements are true

A club charges a flat fee for an open bar (all-you-can-drink). Which statement describes the moral hazard problem in this situation? The marginal cost of another drink becomes zero, encouraging additional consumption. All people become less concerned with morals when they drink. The marginal benefit of another drink is increased, encouraging additional drinking. Rather than attracting a balance of light and heavy drinkers, the flat fee attracts mostly heavy drinkers.

The marginal cost of another drink becomes zero, encouraging additional consumption.

In a town with exactly 1,000 residents, 50 percent of the residents make healthy choices and 50 percent of the residents consistently make unhealthy choices. The health insurance company in town cannot tell, in advance, who is healthy and who is unhealthy. A healthy person has an average of $600 in medical expenses each year and is willing to pay $650 for insurance. An unhealthy person has an average of $1,800 in medical expenses each year and is willing to pay $2,000 for insurance. The health insurance provider can offer insurance at only one price.

In equilibrium, the price of insurance will be at least: $1,800 In equilibrium, who will buy insurance: unhealthy residents

It is possible to adverse selection without moral hazard and vise versa TRUE OR FALSE

TRUE

Adverse selection relates to

Unobserved characteristics of people or goods, it occurs BEFORE the parties have entered into an agreement

Consider the effect of reputation. You are likely to be treated better in which of the following scenarios? You are purchasing your car from a local dealership You are purchasing your car from an individual who advertised it on Craigslist

You are purchasing your car from a local dealership

Information asymmetry becomes a problem when: Multiple Choice · a buyer and seller have aligned incentives. · a market is highly inefficient. · a buyer and seller have opposing incentives. · a market is highly efficient.

a buyer and seller have opposing incentives

Principal-agent problem

a person called a PRINCIPAL entrusts someone else called the AGENT, with a task

Because careless drivers are more likely to seek insurance coverage, insurance companies end up covering many careless drivers, an example of:

adverse selection

The government requires that every driver have some form of car insurance to address the problem of: Multiple Choice · adverse selection. · moral hazard. · statistical discrimination. · illegal screening.

adverse selection

When both sides in a transaction do not have the same information

adverse selection occurs

In best case scenarios adverse selection:

reduces the efficiency of markets because some transactions that would make both sides better off fail to take place, and surplus is lost

A good reputation:

can be viewed as a special form of signaling, is a helpful way for buyers to avoid information asymmetry

Many employers also use proactive screening methods because

candidates have an incentive to hide negative information

What does the bottom line refer to

comes from the accounting -profit that is shown on the last line of a companies income statement for business people this means: is that making a profit is the central goal of a business Economists assume a firms goal is to: maximize profits

Certifying a used car through a brand dealership is one way to: Multiple Choice credibly screen out lemons. credibly signal the car is not a lemon. unreliably signal that the car is not a lemon. unreliably screen out lemons.

credibly signal the car is not a lemon

Statistical discrimination

distinguishing between choices by generalizing based on observable characteristics in order to fill in missing information

The requirement by most states that all drivers buy at least a minimum level of insurance to cover the liability to third parties is a

government regulatory attempt to solve the adverse selection problem

Saying that statistical discrimination can be rational, doesnt meant that

it is always admirable, ethical, or even legal

The key to a successful signal is that

it is not easily faked

Even in best case scenario, adverse selection reduces the efficiency of the market because:

it takes away transactions that could have happened, but didn't because buyers or sellers didn't have the same information and surplus is lost

If the cost of acquiring more information about a good outweighs the benefit of having that extra information, then we can predict that the exchange: will definitely not take place. will not benefit anyone. may take place anyway. will take place, but will be regretted in the future.

may take place anyway

Drivers with auto insurance are more likely to be careless, an example of:

moral hazard

the risk of a bad reputation creates an incentive for the more-informed party

not to take unfair advantage of the information asymmetry

Adverse selection

occurs when buyers and sellers have different information about the quality of a good or the riskiness of a situation, and this asymmetric information results in failure to complete transactions that would have been possible if both sides had the same information

People _____ have _____ when making choices. Multiple Choice always; enough information never; access to complete information always; access to complete information often; good enough information

often; good enough information

Information asymmetry is a situation in which: Multiple Choice one person knows more than another. people have good enough information to make acceptable choices, but not complete information. complete information is not possible to obtain. the lack of information in a market prevents it from existing.

one person knows more than the other

People _____ have access to perfectly complete information. Multiple Choice never rarely often always Bottom of Form

rarely

The nutritional information now available at many fast food restaurants is an example of the government: Multiple Choice screening out unhealthy food for consumers. requiring more informed parties to reveal missing information. attempting to control what people eat. requiring restaurants to signal whether food is healthy or not.

requiring more informed parties to reveal missing information

{ blank } is useful when people would rather not share private information

screening

Auto insurance companies charge higher insurance premiums for plans with lower deductibles as a way of: Multiple Choice · reducing the lemons problem. · avoiding moral hazard. · screening between types of drivers. · optimizing information acquisition.

screening between types of drivers

Approaches to solving these problems

screening, signaling, building a reputation, and using statistical discrimination

3. Agreeing to take a drug test offered by a potential employer is a method of: Multiple Choice screening. signaling. statistical discrimination. building a reputation

signaling

A high school student voluntarily including a writing sample with a college application is an example of: Multiple Choice building a reputation. signaling. screening. statistical discrimination.

signaling

What method is often used when both parties want to eliminate information asymmetry:

signaling

Information asymmetry

situation in which one party is more informed than another because of the possession of private information

Even in the best-case scenario, adverse selection reduces the efficiency of market because

some transactions that would make both sides better off fail to take place, and surplus is lost

Complete Information

state of being fully informed about the choices that relevant economic actors face

Signaling

taking action to reveal one's own private information

Screening

taking action to reveal private information about someone else

They key to a successful positive signaling

that it is not easily faked, for a signal to be credible, it must carry some sort of mechanism or cost that makes it inaccessible or unappealing to those it is meant to exclude

When parties attempting to enter into an agreement lack information: they should always gain more information before making a decision. the cost of acquiring information is sometimes prohibitive. an exchange will never happen. the exchange will happen, but surplus is unlikely to be

the cost of acquiring more information is sometimes prohibitive

What is one way to avoid the principal-agent problem in the workplace? Multiple Choice • The employee constantly monitors the employer's activities. • The employer constantly monitors the employee's efforts. • The employee signs a waiver of release. • The employer shares all management choices with employees before making decisions.

the employee constantly monitors the employee's efforts

Adverse selection occurs in the used car market because the buyer has more information than the seller. the seller has more information than the buyer. both the buyer and the seller have incomplete information. Any of these could be the cause of adverse selection in the used car market.

the seller has more information than the buyer

Moral Hazard

the tendency for people to behave in a riskier way or to renege on contracts when they do not face the full consequences of their actions

People rarely have perfect information, they have

the usually have "good enough" information

In a worst case scenario

the vicious cycle caused by adverse selection can cause markets to fall apart entirely

Information Asymmetry is not a problem when: Multiple Choice the wants of both parties are aligned with one another. both parties lack the same information. the wants of both parties are opposed to one another. the constraints of both parties are identical.

the wants of both parties are aligned with one another

If both parties incentives are aligned

then the information incentive does not matter

People confuse adverse selection with moral hazard because

they often occur together

Adverse selection relates to

unobserved characteristics of people or goods. it occurs BEFORE the parties have entered an agreement

Moral Hazard can be avoided by correcting information asymmetry through better monitoring

which could increase productivity significantly