Exam 17: Markets With Asymmetric Information

Jim's Hardware Supply has theft insurance. Jim also has an alarm system. The alarm system has just recently malfunctioned. If Jim has the alarm system repaired, it will cost him $100. The probability of a theft occurring is If a theft occurs and there is no alarm system, the value of stolen materials will be $125,000. However, Jim's insurance will compensate him fully for the loss. No thefts will occur if the alarm system is in place. What is the expected cost to Jim of repairing the alarm system? What is the expected cost to society of not repairing the alarm system?

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?

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 where y* is an education threshold determined by the employer. They will be offered $130,000 if they have -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:

The problem of adverse selection in health insurance leads to a situation in which:

Figure 17.1.1 -Refer to Figure 17.1.1 above. As buyers of high-quality cars lower their expectations of the average quality of a car in the market,

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 17.3 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. If the fire protection program were not in place, the insurer would not be willing to ensure the warehouse for any amount less than:

Figure 17.6.1 -The "no shirking constraint" (NSC) curve never crosses the supply of labor curve, so:

Firms that contain some divisions that produce parts and components to be used by other divisions in order to generate finished goods are said to be:

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,

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 -Refer to Scenario 17.5. Under which of the following payment schemes would workers have an incentive to exert high effort?

Use the following statements to answer this question: I. Based on the principal-agent framework in economics, we know that the lack of incentive compatibility may arise in private firms but not in public agencies or government bureaus. II) The key problem in principal-agent situations is the principal's fundamental inability to oversee or supervise the agent.

Medical histories used by insurance firms allow them to:

In a competitive labor market, shirking on the job can be a problem. In this market for labor services, the demand for labor is expressed as: W = where W is wage rate (dollars per hour) and L is number employed per unit of time. The no shirking constraint (NSC) is expressed as: NSC = where NSC is the minimum wage workers need not to shirk, and L is the number employed per unit of time. Assume that the labor force L^* = 150,000. Determine the following: a. the level of unemployment that would result when firms pay the efficiency wage b. the market clearing wage c. the efficiency wage

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

Wiz-Bang Games is a new video game maker for the latest game console. As a new game maker, they have not established a reputation of providing quality games. The marginal cost to Wiz-Bang for manufacturing games is: The market price for low-quality games is $20. The market price for high-quality games is $65. If Wiz-Bang sells their product in the low quality market, calculate their producer surplus. If Wiz-Bang sells their product in the high quality market, calculate their producer surplus. If Wiz-Bang spends $12,500 on marketing and packaging, they will be perceived as a high quality producer of video games. Should Wiz-Bang spend the $12,500 to provide a signal to video game consumers of producing high quality games?

Scenario 17.4 Consider the following information: StowUrStuff Storage is located slightly below sea level in a coastal town. It could build and maintain a flood control system around its property at an annual cost of $1000, and if it did so, the probability of a flood's doing $1,000,000 in damage during the year would be .005. With no flood control system, the probability of such a flood would be .01. -Refer to Scenario 17.4. Moral hazard would be eliminated in this situation if:

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 where y* is an education threshold determined by the employer. They will be offered $130,000 if they have -Refer to Scenario 17.1. The highest level of y* that can be set and still have the high-productivity people choose to meet it is:

Because the presence of a warranty for a good is a signal that the good is of high quality,

Scenario 17.4 Consider the following information: StowUrStuff Storage is located slightly below sea level in a coastal town. It could build and maintain a flood control system around its property at an annual cost of $1000, and if it did so, the probability of a flood's doing $1,000,000 in damage during the year would be .005. With no flood control system, the probability of such a flood would be .01. -Refer to Scenario 17.4. If the flood control system were in place, the firm could insure against a flood for an annual premium of: