Exam 17: Markets With Asymmetric Information

Used cars sell for much less than new cars because

Medical histories used by insurance firms allow them to

When sellers have more information about products than buyers do, we would expect

Scenario 17.1 Consider the information below: For Group A the cost of attaining an educational level y is C_A(y) = $6,000y and for Group B the cost of attaining that level is C_B (y) = $10,000y. Employees will be offered $50,000 if they have y < y*, where y* is an education threshold determined by the employer. They will be offered $130,000 if they have y > y^*. -Refer to Scenario 17.1. An employer who only wants to hire individuals who find learning less costly can do so by choosing y^* to be anywhere between

If individuals are paid the wage at which the supply of labor is equal to the demand for labor,

Scenario 17.3 Consider the following information: The probability of a fire in a factory without a fire prevention program is 0.01. The probability of a fire in a factory with a fire protection program is 0.001. If a fire occurred, the value of the loss would be $300,000. A fire prevention program would cost $80 to run. -Refer to Scenario 17.3. Moral hazard arises in this situation because once the firm

Which of the following statements is NOT a reason that the cost of a college education is greater for the low-productivity group than for the high-productivity group?

Trisha's Fashion Boutique is considering a profit sharing arrangement with her employees. Currently, the employees receive an annual bonus. Trisha can sell all the output she produces for $150 per unit. Trisha's total cost function (including bonus payments to employees) is: TC(Q) = 75Q + 2.5Q². The marginal cost function is: MC(Q) = 75 + 5Q. The profit sharing plan would pay employees 30% of profits. However, due to greater cost saving initiatives from employees, Trisha's total cost function becomes: TC(Q) = 50Q + 2Q². The relevant marginal cost function becomes: MC(Q) = 50 + 4Q. Which plan offers Trisha the greatest profits for herself?

Prestige University grants degrees only to high skill students who perform well for their eventual employers. Mediocre University grants degrees only to low skill students. The market demand for newly graduated high skilled workers is: = 5,000 - ^p_H. The market demand for newly graduated low skilled workers is: = 15,000 - ^p_L^. Currently, Prestige University graduates 1,000 students while Mediocre University graduates 5,000. Determine the equilibrium prices for low and high skilled graduates. Suppose that in an effort to cut costs, the State has merged Prestige University and Mediocre University into State University. This merger has eliminated the signal that employers use to rely on to discern graduate quality. As a result, the demand for State University graduates is: Q^D = 10,000 - P. The number of graduates from State University will be 6,000. Calculate the equilibrium price for State University graduates. Before the merger, would students at both Universities be willing to pay higher tuition in an effort to prevent the Universities from merging? Why or why not?

Assume that the owners of a firm know that the firm's profits will depend upon two parameters: (1) how hard the managers work, and (2) the state of the economy. For simplicity, assume that the managers can exert either maximum or minimum effort and that the economy can be either favorable or unfavorable. The profits under various situations are represented by the matrix below. Favorable Unfavorable Economy Economy Maximum Effort 700,000 400,000 Minimum Effort 400,000 200,000 The firm considers there to be an equal probability of either state of the economy. The manager considers the cost of effort to be C = 55,000x, where x = 1 for maximum effort, 0 for minimum effort. The firm is considering the pay scheme described below. Evaluate each alternative in terms of their incentive effects for the manager and their effect on the firm's profitability. a. a flat salary of $30,000 that is not tied to the firm's performance b. a bonus of 0 if profit equals 200,000 or 400,000 and a bonus of 120,000 if profit equals 700,000 c. a bonus determined by the formula: B = 0.20(PROFIT - 300,000) d. a bonus determined by the formula: B = 0.24(PROFIT - 300,000)

Scenario 17.5 Consider the following information: Income to the firm from workers who sell door-to-door Bad Luck Good Luck Low Effort (e = 0) $5,000 $7,000 High Effort (e = 1) $7,000 $13,000 Cost of effort: c = $2500e Probabilities: Bad luck = .75; Good luck = .25 -A principal-agent problem arises in the situation in Scenario 17.5 because

Scenario 17.2 Consider the information below: For Group K the cost of attaining an educational level y is C_K(y) = $2,000y and for Group M the cost of attaining that level is C_M(y) = $4,000y. Employees will be offered $30,000 if they have y < y*, where y* is an education threshold determined by the employer. They will be offered $90,000 if they have y > . -Refer to Scenario 17.2. If the threshold educational level y^* is set at 20,

John is a 55-year-old male smoker, about 50 pounds overweight, who has high blood sugar and drinks to excess a couple of times each month. Because of adverse selection in health insurance,

If the moral hazard problem in automobile driving were to be eliminated, the marginal cost of driving would be

The completion of a degree or course of study is a good labor market signal

Traditionally, the federal government provides disaster relief funds to flood victims so that they can rebuild their homes after a major flood. However, the government has recently denied requests to rebuild some homes that were situated in flood-prone areas. This action represents an attempt to ________ the moral hazard problem associated with building private homes in risky areas.

The market for used cars in a particular region includes both high-quality and low-quality cars. High-quality cars are sold primarily to quality-sensitive customers, while low-quality cars are sold to price-sensitive buyers. The submarkets for high-quality and low-quality cars can be described by the supply and demand curves: Q_D^H = 160,000 12.5P^H Q_S^H = - 48,000 + 13.5P^H Q_D^L = 110,000 - 12.5P^L Q_S^L = 20,000 + 10P^L, where Q_D^H, Q_S^H refer to the quantities demanded and supplied of high-quality cars, Q_D^L, Q_S^L refer to the quantities demanded and supplied of low-quality cars, P^H and P^L refer to the prices of high-quality and low-quality cars. All quantities are measured in cars per month, prices are measured in dollars. a. Assuming that buyers and sellers are both able to distinguish low-quality and high-quality cars, determine the price and quantity that will prevail in each submarket. b. Examine the case where sellers are able to accurately determine used-car quality but buyers are not. You may assume that buyers assume that all cars are of average quality so that an average demand curve is appropriate. Determine the price and quantity in each submarket. c. Using diagrams, analyze the additional developments in the market until final long-run equilibrium is reached. You must describe the eventual outcome, but no calculations are required for this part of the problem.

Over the past several years, the federal government has rescued a few financially distressed banks and other large private companies, and the key reasons for these actions is to stabilize financial markets and to prevent additional business failures that may arise from the original problem. However, critics of these interventions argue that these actions generate a moral hazard problem. Why?

Suppose the plant owners design an incentive scheme for the plant manager in which the feasible production level is set equal to output from the previous quarter. The bonus payment is determined by the formula B = 0.2Q_f + 0.2(Q - Q_f). What potential problems can arise with this scheme?

Augustus bought his BMW convertible as a new car in 1998 and knows that it is in excellent condition. He now wants to sell it and knows that there are many other similar cars on the used car market that are lemons. As a result: