Econ: Chapter 17

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Describe asymmetric information.

1. happens when one party to a transaction has less information than the
other party
2. Asymmetric information is present in the market for used cars because if someone is selling
you a used car, that person has more information about the car than do you

Describe adverse selection.

1. Result of asymmetric information
2. occurs when one party to a transaction takes advantage of knowing
more than the other party

Describe moral hazard.

1. the tendency
of people to change their actions because they have insurance.
2. For example, if you have insurance for
your laptop or iPod, you may reduce your care of those objects

How do insurance companies reduce moral hazard?

use deductibles and
co-payments

Describe moral hazards in labor markets.

Once hired, workers may shirk their obligations and not work hard

How do firms deal with moral hazard?

by closely monitoring workers and making their jobs seem more valuable than other jobs.

Describe information problems in auctions.

1. In some auctions, neither the bidder nor the seller has complete
information about what is being auctioned
2. winner's curse--when the winning bidder overestimates the value of the item and ends up worse off than the losers

Why does asymmetric information exist in financial markets?

firms know more about their financial situation than potential buyers of the firms' stocks and bonds

Describe the principal-agent problem.

1. the conflict between the interests of shareholders and the interests of top management
2. caused by an agent pursuing his own
interests rather than the interests of the principal who hired him.

When does the principal-agent problem arise in labor markets?

1. when workers shirk their obligations and do not work hard

How can firms reduce shirking?

1. through close monitoring of workers or by making a worker's job seem more
valuable
2. pay efficiency wages, which are higher-than-equilibrium wages used to give workers
an incentive to work harder
3. A seniority system that rewards workers who have been with the firm longer with higher pay and other
benefits

1. What is the reason for the existence of asymmetric information?
a. Asymmetric information exists when people who have insurance change their actions because of
the insurance.
b. Asymmetric information exists when one party to an economic transaction has less information
than the other party.
c. Asymmetric information exists when parties to an economic transaction must pay different prices
to obtain the same information.
d. Asymmetric information exists when adverse selection leads to moral hazard.

b. Asymmetric information exists when one party to an economic transaction has less information
than the other party.

Fill in the blanks: Guarding against the effects of asymmetric information is a major objective of
__________ in the insurance market and __________ in financial markets.
a. buyers; sellers
b. sellers; buyers
c. buyers; buyers
d. sellers; sellers

b. sellers; buyers

3. If potential buyers have difficulty separating lemons from good used cars, what will they do?
a. They will take this into account in the prices they are willing to pay.
b. They will not take this into account in the prices they are willing to pay.
c. They will be absolutely indifferent between cars, and will pay the same price for either type of car.
d. They will pay a price for a car that is always too high.

a. They will take this into account in the prices they are willing to pay.

4. When adverse selection exists in the used car market, which of the following will prevail?
a. Buyers will generally offer a very high price, closer to the price of a good car.
b. Buyers will generally offer a very low price, closer to the price of a lemon.
c. Buyers will generally offer a price somewhere between the price they would be willing to pay for
a good car and the price they would be willing to pay for a lemon.
d. All buyers will end up buying a car.

c. Buyers will generally offer a price somewhere between the price they would be willing to pay for
a good car and the price they would be willing to pay for a lemon.

5. Suppose that half of used cars offered for sale are reliable and half are unreliable. If potential buyers
are willing to pay $5,000 for a reliable car, but only $2,500 for an unreliable one, how much will
buyers offer for a car?
a. $2,500
b. $3,750
c. $5,000
d. $4,999

b. $3,750

6. When uninformed buyers are willing to pay a price for used cars that is the average of the value of a
lemon and the value of a good used car, which of the following will occur?
a. Most used cars offered for sale will be lemons.
b. Most used cars offered for sale will not be lemons.
c. The quantity supplied of lemons will be identical to the quantity supplied of good used cars.
d. Only good used cars will be offered for sale.

a. Most used cars offered for sale will be lemons.

7. What is the impact of adverse selection on economic efficiency in a market?
a. Adverse selection will increase economic efficiency.
b. Adverse selection will reduce economic efficiency.
c. Adverse selection does not have any impact on economic efficiency in a market.
d. Consumer wants will shift toward the goods left in the market.

b. Adverse selection will reduce economic efficiency.

8. Which of the following is a way of reducing adverse selection in the car market?
a. Providing manufacturer warranties
b. Providing dealer warranties
c. Building a good reputation
d. All of the above

d. All of the above

9. Which of the following is true about lemon laws?
a. Lemon laws require a full refund if a new car needs several major repairs within the first two
years.
b. Car manufacturers have actually supported lemon laws.
c. Most states today have enacted lemon laws and strictly enforce them.
d. All of the above

a. Lemon laws require a full refund if a new car needs several major repairs within the first two
years

10. Asymmetric information problems are particularly severe in the market for insurance. This is true
because
a. insurance companies will always know more about the likelihood of an event happening than will
buyers of insurance.
b. buyers of insurance will always know more about the likelihood of an event happening than will
insurance companies.
c. insurance companies and buyers of insurance cannot distinguish between good and bad
information.
d. insurance companies are non-depository financial institutions.

b. buyers of insurance will always know more about the likelihood of an event happening than will
insurance companies.

11. Which of the following groups tends to worsen the problem of adverse selection?
a. Good drivers
b. Sick people
c. People living in houses made entirely of rock
d. All of the above

b. Sick people

12. Which of the following makes the adverse selection problem in the health insurance market worse?
a. Charging high premiums for insurance coverage
b. Refusing to offer insurance policies to certain people
c. Requesting a medical examination for new applicants
d. All of the above

a. Charging high premiums for insurance coverage

13. How can insurance companies reduce adverse selection?
a. By offering policies mostly to individuals rather than groups of people
b. By offering group coverage rather than individual coverage
c. By not requiring that every patient buy health insurance
d. By increasing the price of participation in the health insurance program

b. By offering group coverage rather than individual coverage

14. When is it easier for insurance companies to estimate the average number of claims likely to be filed?
a. When they offer policies to individuals, not groups
b. When they offer group coverage rather than individual coverage
c. When they insure small groups rather than large groups
d. When they reduce the number of participants so as to deal with a small rather than large number
of customers

b. When they offer group coverage rather than individual coverage

15. Insurance companies can reduce the problems that arise from adverse selection by offering group
coverage to large firms. Group coverage is an example of
a. risk abatement.
b. risk aversion.
c. risk pooling.
d. hazard reduction.

c. risk pooling.

Which of the following is a consequence of the adverse selection problems insurance companies
face?
a. Insurance companies charge young women higher prices for automobile insurance than they
charge young men.
b. Insurance companies sometimes refuse to offer health insurance to people with chronic illnesses.
c. Insurance companies sometimes refuse to offer group insurance to large companies because there
are too many insured people to accurately price this insurance.
d. The equilibrium quantity of health insurance is greater that it would be in the absence of adverse
selection.

b. Insurance companies sometimes refuse to offer health insurance to people with chronic illnesses.

17. Which of the following is true about adverse selection and moral hazard?
a. Adverse selection is a consequence of asymmetric information; asymmetric information is a
consequence of moral hazard.
b. Insurance companies can eliminate adverse selection by charging deductibles and co-insurance,
but charging deductibles and co-insurance increases the risk of moral hazard.
c. Adverse selection only affects the market for automobile insurance; moral hazard only affects the
markets for health and life insurance.
d. Adverse selection refers to what happens at the time of entering into a transaction; moral hazard
refers to what happens after entering into a transaction.

d. Adverse selection refers to what happens at the time of entering into a transaction; moral hazard
refers to what happens after entering into a transaction.

18. Match one of the terms below to the following definition: Actions taken by one party to a transaction
that are different from what the other party expected at the time of the transaction.
a. Adverse selection
b. Moral hazard
c. The Coase Theorem
d. Winner's curse

b. Moral hazard

19. Which of the following actions is an attempt by a fire insurance company to reduce moral hazard?
a. Requiring a warehouse to install a sprinkler system
b. Reserving the right to inspect the warehouse for fire hazards
c. Establish a system of deductibles and co-payments
d. All of the above

d. All of the above

1) A key difficulty facing insurance companies is that drivers know more about how likely they are to have
accidents than do insurance companies. What is this phenomenon called?
A) asymmetric information.
B) moral hazard.
C) economic irrationality.
D) adverse selection.

A) asymmetric information.

2) When people who buy insurance change their behavior after the purchase because they are protected from loss
by the insurance, the insurance market is said to face the problem of
A) asymmetric information.
B) adverse selection.
C) moral hazard.
D) economic irrationality.

C) moral hazard.

) Asymmetric information is not a problem
A) in the used car market.
B) when buying a product from a perfectly competitive seller.
C) when selling health or life insurance.
D) in financial market transaction

B) when buying a product from a perfectly competitive seller.

4) Consider a used car market in which half the cars are good and half are bad (lemons). If buyers are rational,
the prices being offered for used cars will result in
A) an equal proportion of a good cars and lemons being sold in an efficient market.
B) a larger proportion of good cars being sold and consequently, consumer surplus is increased.
C) an equal proportion of good cars and lemons being sold in an inefficient market.
D) a larger proportion of lemons being sold and consequently, producer surplus is increased

D) a larger proportion of lemons being sold and consequently, producer surplus is increased.

5) The cost of group health insurance is lower than if an individual buys a policy on his own because
A) the problem of adverse selection is reduced.
B) insuring a group eliminates the problem of buyers having more information than the seller.
C) it is easier for the company to deny claims from a large group.
D) moral hazard costs of a group tend to move to a low average

A) the problem of adverse selection is reduced.

6) Which of the following is not an advantage to an insurance company of insuring a large group of people for
health insurance?
A) It is easier to accurately predict the number of claims for a group than for an individual.
B) The characteristics of a large group are likely to reflect those of the entire population.
C) When all group members pay the premium, the problem of adverse selection is reduced.
D) When all group members pay the premium, the problem of moral hazard is reduced.

D) When all group members pay the premium, the problem of moral hazard is reduced.

) Suppose a large firm allows its employees to choose whether to participate in its health insurance plan. The
firm is trying to decide between two plans: Plan I has a low monthly premium but a high deductible, and Plan
II has a high monthly premium but a low deductible. Under which plan is adverse selection likely to be a
bigger problem?
A) Plan II because it is likely to draw participants who expect high medical costs. Healthy individuals who
do not expect to consume much health care services will not be willing to pay the high premiums.
B) Plan I because it is likely to draw participants who expect high medical costs. This group expects to
consume much health care services and therefore prefer low deductibles.
C) Plan I because it is likely to draw the relatively healthy employees who do not expect to spend much on
health care. Because the monthly premiums are low, the insurance company has to bear a bigger
financial burden in the event of serious illnesses.
D) Plan II because it is likely to draw employees who tend to over consume health care services because of
the low deductible. Insurance companies are likely to end up paying out more claims than the premiums
they collect.

A) Plan II because it is likely to draw participants who expect high medical costs. Healthy individuals who
do not expect to consume much health care services will not be willing to pay the high premiums

Health insurance companies impose deductibles on policies and co-payments on claims
A) to increase sales.
B) to reduces sunk costs.
C) to reduce moral hazard problems.
D) to increase prices.

C) to reduce moral hazard problems.

) In markets with asymmetric information
A) asymmetric information causes adverse selection and then it causes moral hazard.
B) moral hazard causes adverse selection which in turn causes asymmetric information.
C) adverse selection causes moral hazard which in turn causes asymmetric information.
D) asymmetric information causes moral hazard and then it causes adverse selection

A) asymmetric information causes adverse selection and then it causes moral hazard.

10) Suppose that there are only two types of auto insurance consumers: good risks and bad risks. A good risk will
have insurance claims of $600 per year, while a bad risk will have insurance
claims of $5,000 per year. If an insurance company has no access to any other sources of information, which of
the following will result if the company charged a premium equal to the expected payout?
A) The bad risks would seek coverage and the good risks would not.
B) Both the bad risks and the good risks are equally likely to seek coverage.
C) There would be fewer bad risks seeking coverage but the total payout by the insurance company would
be higher.
D) The good risks would seek coverage and the bad risks would not

A) The bad risks would seek coverage and the good risks would not.

11) What is the principal-agent problem?
A) It is a problem caused by a person (principal) who hires an agent to act on his behalf but is unwilling to
delegate authority to the agent to carry out the task in the best possible way.
B) It is a problem that exists when a person (principal) has more information about the task than the agent
he hires to perform the task.
C) It is a problem caused by agents pursuing their own interests rather than the interests of
the principals who hired them.
D) It is a problem of the power system of boss and subordinate where the boss (principal) exerts influence
over his subordinates (agents) using punishment or threat.

C) It is a problem caused by agents pursuing their own interests rather than the interests of
the principals who hired them.

12) Which of the following is a moral hazard behind the principal-agent problem that might exist between
management and workers?
A) Once hired, workers may shirk their duties and not work hard.
B) After agreeing to work for a given wage, management reneges on its agreement
C) Workers' goals differ from their employers' goals.
D) Management does not adhere to safety guidelines and thereby put workers at risk.

A) Once hired, workers may shirk their duties and not work hard.

13) All of the following are techniques commonly used to overcome the principal-agent problem except
A) instituting a commission-based compensation scheme for salespersons.
B) awarding profit-sharing bonuses for management.
C) increasing the amount of autonomy for agents to encourage ethical behavior.
D) mandating accountability, for example, requiring a firm's board of directors to certify the accuracy of its
public accounts.

C) increasing the amount of autonomy for agents to encourage ethical behavior.

14) What is the rationale behind a seniority system in which workers wages and other benefits rise with a worker's
tenure in the firm?
A) the belief that a person is more likely to commit herself to a company for the rest of her career if there
exists some form of guarantee that her salary and status in the company will rise with time
B) to retain and attracts high performers while discouraging low performers
C) the recognition that senior workers have "paid their dues" to the firm and justly deserve to reap the
rewards of their long years of high performance
D) to acquire the reputation that the corporation is committed to a "lifetime employment system" under
which the firm guides a worker's career development over the long term.

A) the belief that a person is more likely to commit herself to a company for the rest of her career if there
exists some form of guarantee that her salary and status in the company will rise with time

) In the market for restaurant servers, tips
A) compensate a server for the efficiency wage paid by the employer
B) increase the principal-agent problem because not everyone (for example, dishwashers and busboys)
receives an equal share of the tips.
C) reduce the principal-agent problem by giving servers an incentive to provide good service.
D) allow employers to identify the highly productive servers from the unproductive ones.

reduce the principal-agent problem by giving servers an incentive to provide good service

Suppose the going wage for commercial and residential cleaners is $12 per hour. The Clean Town Crew, a
commercial and residential cleaning service decides to pay its workers $15 per hour. How will this higher
wage affect the firm's profits?
A) It depends on how workers respond to the higher wages. If productivity gains exceed the increased labor
costs, profit will rise but if the higher wages do not result in an appreciable increase in productivity,
profit falls.
B) The firm's profits will rise because the above equilibrium wage will draw high productivity workers,
lead to lower absenteeism and worker turnover and therefore lower labor training costs.
C) The firm's profits will fall because over time the efficiency wage ($15) will become the market wage and
to continue to attract the more talented workers the firm will have to continually increase its labor costs.
D) The firm's profit must rise; otherwise the firm has no incentive to pay above the going wage rate.

) It depends on how workers respond to the higher wages. If productivity gains exceed the increased labor
costs, profit will rise but if the higher wages do not result in an appreciable increase in productivity,
profit falls

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