Friday Econ Test

Firms equate marginal revenue and marginal cost in

- Perfect competition - Monopoly - Monopolistic competition

Two examples that are NOT moral hazard are:

- You go skydiving and sign a waver stating you can't sue the skydiving company of you get hurt. - Your employer pays you wages that are higher than the market rate.

The Coase Theorem will break down when

- there are a large number of agents. - transaction costs become high - when property rights are not clearly defined.

What phenomenon does this example illustrate?

Adverse selection

Why do bad cars drive out the good ones in the market for used cars?

Buyers are not able to tell the difference between good cars and bad cars, and so they are not willing to pay a high price for a used car because of the significant chance it will be a lemon, which makes owners of good cars unwilling to sell them.

What does the model suggest about crime prevention?

Crime can be solved with the right incentives, which will be in part a function of the expected punishment.

How can crime and punishment be modeled as a principal-agent problem?

Crime can be viewed as a principal-agent relationship under moral hazard because the actions of the agent, whether he or she has broken the law or committed a crime, are not perfectly observable by the principal, in this case, the state or the government.

Asymmetric information might not necessarily require government intervention.

First, in some cases, there are market solutions that can address the problem. Second, it might be difficult for the government to gain enough market knowledge to significantly improve market outcomes.

What effect would grade inflation have on effectiveness of college degrees and grades as signals?

It reduces the effectiveness of grades as a signal in the job market.

Firms earn economic profits in the long run in

Monopoly only

Both monopolies and monopolistically competitive firms set marginal revenue equal to marginal cost to maximize profit. Given the same cost curves, would you expect prices to be higher in a monopoly or a monopolistically competitive market?

Monopoly, because its demand is more inelastic.

Does the presence of asymmetrical information necessarily imply that governments should intervene in a market?

No, there may be market solutions or it might be difficult for the government to gain enough knowledge to improve market outcomes.

Does the presence of asymmetric information necessarily imply that governments should intervene in a market?

No, there may be market solutions or it might be difficult for the government to gain enough market knowledge to improve market outcomes.

What is the intent of a Pigouvian tax?

To induce producers of a negative externality to reduce production to the socially optimal level.

How does a command-and-control policy differ from a market-based policy?

With a command-and-control policy, the government directly regulates the allocation of resources, while with a market-based policy, the government provides incentives for private organizations to internalize the externality.

One of the most important government intervention is

market failure.

Efficiency wages, deductibles, and co-payments are all examples of market solutions for minimizing

moral hazard.

The likely result from paying higher wages for more arrests is

moral hazard.

Moral hazard occurs when

one party in a market transaction takes a hidden action that is relevant for, but not observed by, the other party.

Monopolistically competitive firms maximize profits by

producing that quantity where the marginal cost of production equals marginal revenue. MC=MR

The profit-maximizing price is

that price indicated by the demand curve at the profit-maximizing quantity.

Generous unemployment benefits imply

weaker incentives to look for work and the possibility of a longer duration of employment.

Moral hazard occurs

when a principal cannot observe the actions of an agent.

Governments respond to externalities in two main ways:

1. Command-and-control policies, in which the government directly regulates the allocation of resources. 2. Market-based policies, in which the government provides incentives for private organizations to internalize the externality.

Suppose the production of a particular good causes a negative externality. Based on market forces only, how will this impact the production levels for a factory if negative externalities are present?

It will produce the good above the socially efficient level.

An example that is not an externality:

Jordan has lung cancer.

Would it be a good idea to pay higher wages to police officers if they make more arrests?

No, it is likely a large number of the arrests made would not be warranted and would only be made in order to earn higher wages.

Firms equate price and marginal cost in

Perfect Competition only.

Screening also involves private information but is somewhat different from signaling.

Signaling refers to an action taken by an uninformed person to learn about someone else's private information. For example: You are engaging in screening if you have a mechanic inspect a used car you are considering buying.

What happens in a monopolistically competitive market when new firms enter the market?

The existing firm's demand curve shifts in and becomes flatter.

An example of private information is

The way a person drive a rental car.

Negative and positive externalities lead to "wrong" equilibrium quantities and prices.

They do so because they create an external cost or external benefit that is not reflected in the market price.

How do third-party certifications such as Carfax and warranties solve the adverse selection problem in the used car market?

They signal that a good car is not a lemon.

Even if government intervention is not warranted to address the asymmetrical information problems in markets on efficiency grounds, why might intervention be justified?

To ensure a more equitable distribution of income and resources in the society.

Why might someone go to college to earn a college degree and work hard to earn high grades?

To send a signal to potential employers that they are smarter and harder working than the rest of the job applicants.

Signaling refers to

an action that an individual with private information takes in order to convince other about his information.

Firms pay efficiency wages when

an employer either cannot observe the actions of its employees or it is prohibitively expensive to monitor employees.

Adverse selection occurs in the health insurance market because

buyers have private information about their health that the health insurance companies do not.

Firms pay efficiency wages when an employer - principal either

cannot observe the actions of its employees - agent or it is prohibitively expensive to monitor employees.

Externalities such as pollutants which are negative externality, and education which is positive externality,

cause market inefficiencies.

Externalities are called market failures because they

cause markets to produce suboptimal social outcomes.

Moral hazard refers to

hidden actions that individuals take that affect the payoff of others.

Two kinds of asymmetric information are

hidden characteristics and hidden actions

In the case of unemployment benefits, moral hazard occurs because

how hard a worker is trying to find a job or what possibilities he is turning down is private information and unemployed benefits imply weaker incentives to find a job, which leads to a longer duration of unemployment.

When moral hazard is present,

individuals take actions that are their private information and affect the payoffs of others.

The relationship between moral hazard and efficiency wages

is that efficiency wages are used by employers - principals to eliminate or reduce the temptation of the employees - agents - to shirk work because they know the employer cannot catch them shirking.

The principal-agent relationship

is where the principal designs a contract specifying the payments to the agents as a function of his or her performance, and the agent takes an action that influences a performance and thus the payoff of the principal.

An individual or a firm can internalize an externality by

paying the cost of the externality.

The Coase Theorem states that

private bargaining will result in an efficient allocation of resources.

In a monopolistically competitive market, a firm earning negative economic profit in the short run will

produce only if price is greater than average variable cost.

Asymmetric information in a market affects

the functioning of the invisible hand, which can lead to market failure.

For private bargaining to be effective,

the property rights must be well defined, divisible, and defensible. Additionally, transaction costs to bargain must be low.

Adverse selection occurs

when one agent in a transaction knows about a hidden characteristic of a good and this information causes him or her to select in and out of markets.

Asymmetric information is

when one party to a transaction has different information from the other - information that the other party cares about.