Exam 16: Asymmetric Information

Myra drives a Honda Accord, the most stolen car in the United States. She can take precautions to prevent her car from being stolen. The marginal benefit and marginal cost of these actions are MB = 10 - 0.2A and MC = 2 + 0.6A, where A is the number of precautions. Myra values her car, a 1994 model, at $2,400. a. Graph Myra's MB and MC curves and show the optimal number of precautions. b. Suppose that Myra adds comprehensive coverage to her car insurance, which will reimburse her $2,400 if her car is stolen. Using MB and MC curves, show Myra's optimal number of precautions.

Ideally, regulations that address low-quality cars should:

Explain how moral hazard could arise in the following situations. a. The federal government offers flood insurance for homes. b. An NBA (National Basketball Association) player signs a long-term guaranteed contract. c. The government lengthens the time to collect unemployment benefits from 26 to 99 weeks. d. In an area where the roads are frequently snow-covered and icy, a person trades in her rear-wheel drive sports car for a four-wheel-drive SUV.

(Table: Car Quality Rating) At a sale of used cars, nine people are trying to sell their cars. Each of the sellers knows the quality rating of his car, all of which the table displays, and which range from 0 to 2. Sellers value their car at 1,000Q, where Q is its quality rating. Buyers do not know the value of any given car, but they do know the average quality rating of all cars that are available at the going price. Buyers value any given car at , where Is the average quality rating of the cars available for sale. At an auction price of $500, there will be ____ cars for sale.

A small town has 1,000 people, 600 of whom are healthy and 400 of whom are sick. The annual expected medical claims of the healthy and sick are $500 and $9,000, respectively. If the insurance company cannot determine who is healthy and who is sick prior to the purchase of insurance, adverse selection ___ likely to happen because ____.

The new Camaro SS has a 6.2-liter V8 engine that puts out over 400 horsepower. At the racetrack, the Camaro runs the quarter mile in an impressive 12.9 seconds at 117 mph. General Motors provides a three-year warranty on the Camaro. How might the factory warranty set up a moral hazard? What could General Motors do to mitigate the moral hazard?