Deck 17: Markets With Asymmetric Information

Question 1

How do online auction sites like Ebay attempt to overcome the asymmetric information problems associated with goods that the buyer cannot personally inspect before purchase?

A) The online auction firm only allows high-quality merchandise to be sold at their site.
B) The previous performance (reputations) of the buyer and seller are posted for public review.
C) Buyers can take receipt of any goods before they have to pay the seller.
D) all of the above

Answer 1

B

Question 2

Assume that both high and low quality appliances are sold in the used appliance market. If we assume asymmetric information with sellers having more information regarding quality than buyers, which of the following is necessarily true? The

A) fraction of high quality appliances will be greater than under perfect knowledge.
B) fractions of high and low quality appliances will be the same as with perfect information.
C) fraction of high quality appliances will be less than with perfect information.
D) none of the above

Answer 2

C

Question 3

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,

A) John is less likely to buy health insurance than the average person, because the average person's policy premiums will be based on his risk, not the average risk.
B) John is more likely to buy health insurance than the average person, because his policy premiums will be based on the average risk, not his personal risk.
C) when John gets health insurance, he will be less likely to take care of himself.
D) when John gets health insurance, he will be more likely to take care of himself.
E) if John doesn't have health insurance already, he will not be able to get it.

Answer 3

B

Question 4

Credit histories allow firms to

A) identify high-risk borrowers, so they can be eliminated and interest rates kept down for others.
B) increase the number of credit cards issued, and interest rates go up as a result.
C) increase the number of credit cards issued, and interest rates go down as a result.
D) lower the number of credit cards issued, and interest rates go up as a result.
E) increase market power in the credit card industry, raising interest rates.

Question 5

Assume that a particular state has decided to outlaw the sharing of individuals' credit histories as an illegal invasion of privacy. As a result of this action we would expect the

A) cost of borrowing money to rise.
B) number of loans to unworthy credit risks to rise.
C) problems of asymmetric information to become more severe.
D) all of the above
E) none of the above

Question 6

Medical histories used by insurance firms allow them to

A) identify high-risk people, so they can be denied insurance and premiums kept down for low risk people.
B) increase the number of policies issued, raising premiums as a result.
C) increase the number of policies issued, lowering premiums as a result.
D) lower the number of policies issued, raising premiums.
E) increase market power in the insurance industry, raising premiums.

Question 7

When asymmetric information problems drive high quality products from a market, we refer to this situation as:

A) adverse selection.
B) moral hazard.
C) a lemons problem.
D) A and C are correct.
E) B and C are correct.

Question 8

You want to add a new room on your house, but you are not familiar with the local building contractors and are not sure who to consider for the job. If you ask your friends for referrals, you are using their past experience as a way to evaluate the ________ of the builders.

A) efficiency wages
B) moral hazard
C) asymmetric information
D) reputation

Question 9

Julia is a 28-year-old nonsmoking, non-drinking female of normal weight. Because of adverse selection in health insurance,

A) She will be charged less for her premiums than people who are higher risks.
B) She is less likely to buy health insurance than the average person, because policy premiums are based on expected medical expenditures of people who are less healthy than she is.
C) When she get health insurance, she will be less likely to take care of herself.
D) She must get health insurance early in life, and is likely to lose health insurance if she smokes, drinks to excess, or gains weight.
E) She is more likely than the average person to buy health insurance, because she is more likely to be offered it.

Question 10

In the text, the authors present evidence that the market for free agents in professional baseball is subject to the lemons problem. How could a prospective free agent overcome this problem when seeking a new contract?

A) Agree to accept a lower salary with a new team.
B) Rely on standardization to avoid the asymmetric information problem.
C) Decide to negotiate only with their current team.
D) Develop a reputation as a reliable and productive player.

Question 11

When states make car insurance mandatory for all drivers, it

A) raises rates for everyone because it brings bad drivers into the pool.
B) raises rates for high-risk drivers.
C) may lower rates for all drivers to the extent that it keeps low-risk drivers in the pool.
D) prevents high-risk drivers from "selecting out," to the detriment of low-risk drivers.
E) increases the amount of information available to insurers about the population.

Question 12

In the arena of asymmetric information, standardization (for example, menus at McDonald's restaurants) is a substitute for

A) quality.
B) government regulation.
C) reputation of individual sellers.
D) firms' distinguishing among buyers.
E) firms' segregation of buyers.

Question 13

Used cars sell for much less than new cars because

A) of imperfect competition in the automobile industry.
B) buyers know much more about the quality of used cars than sellers do.
C) sellers know much more about the quality of used cars than buyers do.
D) physical depreciation of used cars is very high.
E) of licensing arrangements by the government.

Question 14

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

A) sellers to get higher prices for their goods than they could otherwise.
B) buyers to pay lower prices for goods than they would otherwise.
C) high-quality goods to drive low-quality goods out of the market.
D) low-quality goods to drive high-quality goods out of the market.

Question 15

Consider a market in which high-quality and low-quality television sets are sold. Before consumers make a purchase, they do not know the quality of the sets, but the sellers do know. As compared to a situation where both consumers and sellers know the quality of the sets, this situation would

A) cause no change in the ratio of low to high-quality sets sold.
B) increase the fraction of high-quality sets sold.
C) increase the fraction of low-quality sets sold.
D) cause the average price of goods sold to rise.

Question 16

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:

A) he should be able to sell my car at a premium price because of its excellent condition.
B) he will have to accept a lower price for his car because buyers might think that it is a lemon.
C) he will not be able to sell his car unless he offers some sort of guarantee.
D) he will get the best price for his car by selling it to a dealer.

Question 17

Which of the following represent examples of adverse selection?

A) Unhealthy people are more likely to want health insurance.
B) Careless drivers purchasing extra auto insurance.
C) Risk averse individuals choosing to buy extra insurance.
D) all of the above
E) A and B only

Question 18

The problem of adverse selection in insurance results in a situation in which

A) people choose inappropriate or inadequate coverage because they do not understand the complex information in the policies.
B) people choose too much coverage because they do not understand the complex information in the policies.
C) people choose too little coverage because they do not understand the complex information in the policies.
D) unhealthy people become more likely to buy insurance than healthy people, which drives premiums up, which drives even more healthy people away from the market.
E) healthy people become more likely to buy insurance than unhealthy people, which drives premiums up, which drives even more unhealthy people away from the market even though they are the ones who need it most.

Question 19

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

A) health insurance covers inappropriate items for the population it serves.
B) overinsurance of the premium-paying population occurs.
C) underinsurance of the premium-paying population occurs.
D) the percentage of the premium-paying population that is healthy rises, squeezing unhealthy individuals out of the market.
E) the percentage of the premium-paying population that is unhealthy rises, squeezing healthy individuals out of the market.

Question 20

When firms participate in group health insurance for all employees, it

A) raises rates for everyone, because it brings unhealthy people into the pool.
B) raises rates for unhealthy people.
C) may lower rates for all people to the extent that it keeps healthy people in the pool.
D) prevents unhealthy people from "selecting out," to the detriment of healthy people.
E) increases the amount of information available to insurers about the population.

Question 21

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

A) only if what is learned in that educational process relates directly to the job the individual is being considered for.
B) only if there is a positive correlation between academic success and wage income.
C) primarily because individuals develop good habits in college that serve them well in other areas later on.
D) because all individuals have the opportunity (in the United States) to pursue higher education.
E) because people who possess the traits that make them more productive in the workplace have an easier time completing an education than those who don't.

Question 22

If grades are to be a successful signal to potential employers of a student's qualities, then higher grades must be

A) easier for high-productivity students to earn than for low-productivity students to earn.
B) easier for low-productivity students to earn than for high-productivity students to earn.
C) easy for employers to check.
D) used for all future promotions within the firm.
E) often referred to in the hiring process.

Question 23

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. The highest level of y* that can be set and still have the high-productivity people choose to meet it is

A) 16.
B) 13 1/3.
C) 13.
D) 8.
E) 0.

Question 24

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

A) 7 and 14.
B) 8 and 13 1/3.
C) 10 and 16.
D) 13 1/3 and 20.
E) 14 and 20.

Question 25

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. If the threshold educational level y^* is set at 14,

A) only individuals in Group A will attain it.
B) only individuals in Group B will attain it.
C) individuals in both groups will attain it.
D) no individuals will attain it.
E) some fraction of individuals in each group will attain it.

Question 26

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

A) consumers are willing and able to pay more for a good that carries a warranty.
B) consumers are willing to buy goods if and only if the goods come with warranties.
C) producers do not need to charge extra for warranties.
D) producers can use warranties to sort out high-risk customers.
E) producers must make warranties available on all goods.

Question 27

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?

A) The wages they give up by going to college instead of working will tend to be higher for them.
B) They may have to pay for tutoring services or other extra help to accomplish the same educational goal.
C) They may have to take remedial classes, which would increase the length of time it takes to accomplish the same goal.
D) Even if they take no remedial classes, they may have to spend more time studying for each class, and the value of their leisure time needs to be considered in the calculation.
E) Based on previous signaling, such as from their high school grades or SATs, they may receive less merit-based financial assistance, and thus be under a greater financial strain during their college years.

Question 28

How does the federal government avoid the asymmetric information problem associated with providing health care to people over 65 years of age?

A) Health care is standardized and is the same for all people over 65 years of age.
B) Health insurers rely on the reputation of the covered individuals.
C) Participation in the Medicare program is mandatory for all people over 65 years of age.
D) Health information about people enrolled in the Medicare program is publically available.

Question 29

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. The highest level of y^* that can be set and still have the high-productivity people choose to meet it is

A) 90.
B) 60.
C) 30.
D) 22.5.
E) 15.

Question 30

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. The lowest level of y^* that can be set and still have only the high-productivity people meet it is

A) 90.
B) 60.
C) 30.
D) 22.5.
E) 15.

Question 31

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. The lowest level of y^* that can be set and still have only the high-productivity people meet it is

A) 16.
B) 13 1/3.
C) 13.
D) 8.
E) 0.

Question 32

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. If the threshold educational level y^* is set at 10,

A) only individuals in Group A will attain it.
B) only individuals in Group B will attain it.
C) individuals in both groups will attain it.
D) no individuals will attain it.
E) some fraction of individuals in each group will attain it.

Question 33

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 45,

A) only individuals in Group K will attain it.
B) only individuals in Group M will attain it.
C) individuals in both groups will attain it.
D) no individuals will attain it.
E) some fraction of individuals in each group will attain it.

Question 34

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. An employer who only wants to hire those people who find learning less costly can do so by choosing y^* to be anywhere between

A) 15 and 45.
B) 15 and 30.
C) 13 1/3 and 30.
D) 8 and 20.
E) none of the above

Question 35

As part of the most recent collective bargaining agreement with state employees, a state government must offer dental insurance at "reasonable, nonprofit rates." The state plans to self insure in place of using a private insurance company. Statistical evidence suggests that the average household currently spends $300 per year for corrective dental work and $80 for routine checkups. Administrative costs are expected to average $20 per family. The collective bargaining agreement dictates that the plan's coverages and rates be fixed for a period of three years. The auditor considers the choice of the plan to be extremely important. Consequently, the auditor has asked you to evaluate the three proposals listed below in terms of their propensity to result in adverse selection and/or moral hazard. Proposal 1 would charge a $400 premium with no deductible. Coverage is extended to preexisting conditions, but to cover the nondeductible clause, routine checkups are not covered. Proposal 2 charges a $200 premium with a $200 deductible. The plan does not cover preexisting conditions, but does cover routine office visits. Proposal 3 charges a $150 premium with a $150 deductible. This plan doesn't cover preexisting conditions or routine checkups. The collective bargaining agreement dictates that participation in the plan must be at the employee's option.

Question 36

Explain the nature and consequences of asymmetric information for each of the following cases. What options are available in each instance to reduce the problem?
a. medical insurance
b. issuance of credit cards
c. professional athletes
d. market for used appliances

Question 37

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.

Question 38

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 13 1/3,

A) only individuals in Group K will attain it.
B) only individuals in Group M will attain it.
C) individuals in both groups will attain it.
D) no individuals will attain it.
E) some fraction of individuals in each group will attain it.

Question 39

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. If the threshold educational level y^* is set at 7,

A) only individuals in Group A will attain it.
B) only individuals in Group B will attain it.
C) individuals in both groups will attain it.
D) no individuals will attain it.
E) some fraction of individuals in each group will attain it.

Question 40

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,

A) only individuals in Group K will attain it.
B) only individuals in Group M will attain it.
C) individuals in both groups will attain it.
D) no individuals will attain it.
E) some fraction of individuals in each group will attain it.

Question 41

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

A) pays the premium that is based on the 0.001 probability, it has no incentive to spend the additional $80 for the fire protection program, so the true probability of loss is no longer 0.001.
B) pays the premium that is based on the 0.01 probability, it has no incentive to spend the additional $80 for the fire protection program, so the true probability of loss is no longer 0.01.
C) puts the fire protection program in place, it has less incentive to spend $300 for a premium, leaving the firm underinsured.
D) puts the fire protection program in place, it has less incentive to spend $6,000 for a premium, leaving the firm underinsured.
E) puts the fire protection program in place, it will consider that a substitute for insurance and not be able to deal with the loss from a fire should it occur.

Question 42

Which of the following is TRUE about a college education as a signaling device?

A) It is a useful signal only if individuals choose majors related to their ultimate field of employment.
B) It is a useful signal only if a college education is open to all individuals, no matter what their previous level of educational accomplishment was.
C) It is a useful signal whether or not people actually learn anything in college.
D) It is a useful signal only if the job in question cannot be done without the preparatory coursework the college degree required.
E) It is less and less a useful signal in the post-industrial economy, where the skill sets employers need change so rapidly.

Question 43

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

A) lowered enough to pull the amount of driving back down to the efficient level.
B) lowered enough to raise the amount of driving back up to the efficient level.
C) raised enough to pull the amount of driving back down to the efficient level.
D) raised enough to raise the amount of driving back up to the efficient level.
E) lowered back down to the efficient level, relieving the stress on market forces.

Question 44

The process by which sellers send signals to buyers conveying information about product quality is known as:

A) asymmetric information.
B) market signaling.
C) a lemons problem.
D) moral hazard.

Question 45

Which of the following job market signals are less costly for high-quality workers to send than low-quality workers?

A) Spending long hours at the office
B) Sending emails to coworkers and supervisors at night and on weekends
C) Leaving voice-mail message for colleagues before or after regular business hours
D) all of the above

Question 46

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

A) $80.
B) $300.
C) $3,000.
D) $6,000.
E) $300,000.

Question 47

In the insurance market, "moral hazard" refers to the problem that

A) insurers can't tell high-risk customers from low-risk customers.
B) high-risk customers have an incentive to give false signals to make themselves look like low-risk customers.
C) companies may unfairly lump individuals together by race, sex, age or other characteristics in an attempt to use demographic data to pinpoint high-risk populations.
D) individuals are willing and able to pay different amounts for insurance, but must all be charged the same amount.
E) individuals may change their behavior after the insurance is bought, so that they behave in a more high-risk manner than they did before.

Question 48

A bumper-to-bumper warranty on a used car is a signaling device that

A) identifies a high-quality car as a high-quality car, because putting such a warranty on a low-quality car would be prohibitively costly.
B) disguises a low-quality car as a high-quality car, and thus makes it easier to sell.
C) is necessary in order to sell a low-quality car at all. Without it no one would risk buying the car.
D) isn't necessary if there is a mix of high-quality and low-quality cars in the market.
E) helps sellers determine whether the buyer is truly looking for a high-quality car.

Question 49

Job market signals like dressing well for interviews are not especially effective because:

A) the cost of dressing well is about the same for high-quality and low-quality workers.
B) many businesses have adopted casual office attire, so dressing well is not important to the firm.
C) federal labor laws prohibit firms from using dress or appearance as an employment criterion.
D) none of the above

Question 50

Many business professionals constantly monitor their incoming email and text messages so they can appear to be alert and responsive, even at night and on weekends. Alternatively, some time management consultants recommend that business professionals should not constantly check for new messages because this practice distracts the worker from scheduled tasks that may have higher priority. The decision to check email or text messages less frequently may not harm the worker's salary if it is a:

A) weak signal of worker ability.
B) weak signal of cell phone strength.
C) strong signal of worker ability.
D) strong signal of ease of distraction.

Question 51

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 in place, the company could insure the warehouse for a premium equal to

A) the loss from the fire, $300,000.
B) the expected loss from the fire, $300.
C) the expected loss from the fire, $3,000.
D) the cost of the fire protection program, $80.
E) $0.

Question 52

A certain firm can hire two types of workers: Group A workers who have high productivity and Group B workers with low productivity. Group A workers will add $27,500 to the firm's revenues per year, while Group B workers will increase the firm's revenues by $15,000 per year. The firm's managers expect workers to be employed for eight years. The differences in the workers' productivity levels are reflected in their costs per year of education. Each year of education (which includes the psychic costs of study effort) costs an A worker $12,500, while each year costs a B worker $25,000.
a. Under competitive conditions, how much would A and B workers earn?
b. Assuming that the firm is unable to distinguish A from B workers and that it is equally likely that a worker is of either type, what pay scale will the firm offer?
c. Suppose that the firm decides to use education as a market signaling device to distinguish A workers from B workers. What education requirement could the firm set?

Question 53

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 there is no insurance and a fire protection program in place, the expected loss from fire for this company is

A) $0.
B) $300.
C) $3,000.
D) $6,000.
E) $300,000.

Question 54

When a moral hazard problem exists for automobile driving, the marginal cost of driving

A) is lowered, and the amount of driving done is raised above the efficient level.
B) is lowered, and the amount of driving done is lowered below the efficient level.
C) is raised, and the amount of driving done is raised above the efficient level.
D) is raised, and the amount of driving done is lowered below the efficient level.
E) is raised above the efficient level, but market forces keep the total amount of driving is kept at the efficient level.

Question 55

Which of the following would be LEAST likely to contribute to a moral hazard problem among drivers?

A) Provide medical coverage to all drivers, their passengers, and any and all individuals involved in the accident, no matter who was at fault.
B) Provide medical coverage and car repair/replacement coverage to drivers, their passengers, and any and all individuals involved in the accident, no matter who was at fault.
C) Modify all cars to remove the driver's seatbelt and the steering wheel air bag.
D) Pass a law limiting the amount of damages that juries may award in accident cases.
E) Make automobile insurance mandatory for all drivers.

Question 56

Which of the following is TRUE about producers' willingness to offer warranties on products?

A) Producers are equally likely to offer warranties on high-quality and low-quality goods.
B) Producers are more likely to offer warranties on low-quality goods, because without the signal that the warranty provides, the low-quality good wouldn't sell.
C) Producers are more likely to offer warranties on high-quality goods, because the expected cost of repairs is lower for those goods.
D) Producers have an incentive to deal with third-party companies to provide the warranties, so that an "impartial" view of the product is given to the consumer.
E) Producers will not offer warranties in any market that suffers from asymmetric information.

Question 57

A warranty is most valuable as a signaling device when

A) the buyer has much more information about the product than the seller does.
B) the seller has much more information about the product than the buyer does.
C) the buyer has much more information about his or her own preferences than the seller does.
D) neither the buyer nor the seller has good information about the product.
E) neither the buyer nor the seller has good information about consumer preferences.

Question 58

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 there is no insurance and no fire protection program in place, the expected loss from fire for this company is

A) $0.
B) $300.
C) $3,000.
D) $6,000.
E) $300,000.

Question 59

Over the past several decades, low-productivity and high-productivity workers in the US and other countries have tended to invest in their own human capital by completing more years of college than earlier generations. Which of the following reasons does NOT help to explain this trend?

A) The cost of education for low-productivity workers has declined due to the emergence of online and other nontraditional programs.
B) The earnings gap between workers with and without education has grown larger over time.
C) The cost of education for high-productivity workers has increased over time.
D) The benefit associated with increased education has increased over time.

Question 60

In this problem, a labor market exists where employers hire and pay workers according to how much formal education workers possess. Education is a proxy for the level of productivity that employers can expect from workers. Therefore, employers follow a strategy in which they hire workers and pay salaries according to the following conditions:
Degrees Above the Values of Post High School
High School Level Education During Working Life, B(y)
None 0
(y = 0 years)
Associate's Degree $30,000
(y = 2 years)
Bachelor's Degree $51,000
(y = 4 years)
Master's Degree $58,000
(y = 6 years)
Assume that there are only two types of worker abilities, those who are less productive (type L) and those who are highly productive (type H). The less productive workers have to study harder than highly productive workers in order to earn any degree. Consequently, the costs (including the psychic costs of study effort) of attaining various levels of education for these two types of employees are different.
For less productive workers: C_L(y) = $13,000y
For highly productive workers: C_H(y) = $10,000y
a. Draw a diagram with years of education on the horizontal axis. Graph the benefits to education B(y) and the costs of education for each of the two types of workers. Discuss what level of education each type of worker should obtain.
b. Now use the equations above to verify your answer from part (a) mathematically.
c. Explain the value of formal education above the high school level in the market place to employers.

Question 61

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?

A) Government oversight of rescued firms is typically based on limited information, so the outcome is economically inefficient.
B) Rescued firms will have a difficult time buying insurance in private markets, so the government will also have to insure the firm against losses from fire, theft, etc.
C) Managers have more information about the financial strength of their firm than government officials, so the rescue attempts may be unnecessary.
D) Managers may be more likely to invest in risky projects if they believe the government will save the firm in case of failure.

Question 62

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 arises in this situation because once the firm

A) pays the premium that is based on the .005 probability, it has no incentive to spend the additional $1000 for the flood control system, so the true probability of loss is no longer .005.
B) pays the premium that is based on the .01 probability, it has no incentive to spend the additional $1000 for the flood control system, so the true probability of loss is no longer .01.
C) provides for flood control, it has less incentive to spend $5000 on premiums, leaving itself underinsured.
D) provides for flood control, it has less incentive to spend $10,000 on premiums, leaving itself underinsured.
E) provides for flood control, it will consider that a substitute for insurance and not be able to deal with the loss from a flood should it occur.

Question 63

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 there is no flood insurance and no flood control system is in place, the expected loss from a flood is

A) $5,000.
B) $10,000.
C) $100,000.
D) $200,000.
E) $1,000,000.

Question 64

In insurance markets, moral hazard creates economic inefficiency because:

A) insurance companies are price setters rather than price takers.
B) insurance products are not homogenous goods.
C) there are many buyers but only a few sellers.
D) insured individuals do not correctly perceive the costs or benefits of their actions.

Question 65

The presence of deposit insurance in the savings and loan industry

A) created an adverse selection problem because good S&Ls were forced out of the market.
B) solved its own adverse selection problem because it pushed badly managed S&Ls out of the market.
C) contributed to "depositor moral hazard" but did not involve a moral hazard problem with owners.
D) contributed to "moral hazard by owners" but did not involve a moral hazard problem with depositors.
E) contributed to both "depositor moral hazard" and "moral hazard by owners."

Question 66

Which of the following is NOT an example of moral hazard in business?

A) A bank buys risky mortgage securities because they believe the government will provide a bail-out if the investment performs badly.
B) A firm uses venture capital to speculate in the commodity futures market.
C) A firm does not hire adequate security protection for its warehouse after it pays for insurance on the property.
D) Firms with the large debt problems are more likely to apply for bank loans than financially stable firms.

Question 67

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 not in place, the insurer would not be willing to insure against the flood for any premium less than

A) $5,000.
B) $10,000.
C) $100,000.
D) $200,000.
E) $1,000,000.

Question 68

The principal-agent problem in corporations exists because the managers of a firm

A) may pursue their own goals even when the result is lower profit for owners.
B) may know how to operate the business better than absentee owners do, and yet not be allowed to.
C) are generally unable to do the monitoring that would result in the firm's avoiding moral hazard problems.
D) are generally unable to do the monitoring that would result in the firm's avoiding adverse selection.
E) are generally unable to monitor workers, who do not care about the profits due the managers.

Question 69

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

A) the insurer would always charge $5000.
B) the insurer would always charge $10,000.
C) the insurer could costlessly monitor whether a flood control system is in place, and adjust the premium upward if it is not.
D) the insurer could costlessly monitor whether a flood control system is in place, and adjust the premium downward if it is not.
E) the flood did not occur.

Question 70

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. If low effort is exerted, expected income is

A) $5000.
B) $5500.
C) $6000.
D) $6500.
E) $7000.

Question 71

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 there is no flood insurance and the flood control system is in place, the expected loss from a flood is

A) $5,000.
B) $10,000.
C) $100,000.
D) $200,000.
E) $1,000,000.

Question 72

Moral hazard may arise in lending when small firms borrow funds from banks for one project (e.g., buy new machinery for a factory) and actually use the funds in other ways (e.g., buy the manager a new corporate jet). What is the source of the asymmetric information problem in this case?

A) The bank has more information about the true cost of the corporate jet than the firm.
B) The bank has more information about the opportunity cost of the loaned funds.
C) The firm has more information about the actual use of the funds than the bank.
D) The firm has more information about the interest rate on the loan than the bank.

Question 73

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

A) the principal can measure effort and output; the agent can measure only output.
B) the principal can measure only effort, and the agent can measure only output.
C) the principal can measure only output, and the agent can measure effort and output.
D) neither the principal nor the agent can measure effort.
E) neither the principal nor the agent can measure output.

Question 74

Managers' pursuit of which of the following objectives would NOT lead to a principal-agent problem in a corporation?

A) The corporation's growth
B) Increased market share for the corporation
C) The maximum possible profit for the corporation
D) A great "golden parachute" or retirement package
E) Increased current salary and fringe benefits

Question 75

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.

A) enhance
B) mitigate
C) legalize
D) support

Question 76

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 would be eliminated in this situation if

A) the insurer would always charge $300.
B) the insurer would always charge $6000.
C) the insurer could costlessly monitor whether a fire prevention program has been implemented, and adjust the premium upward if it is not.
D) the insurer could costlessly monitor whether a fire prevention program has been implemented, and adjust the premium downward if it is not.
E) the fire did not occur.

Question 77

The principal-agent problem of ownership vs. control of the corporation tends to get worse when

A) stock in a corporation is held exclusively by a small number of people who control the company's day-to-day operations.
B) stock in the company is tightly held, but there are some "outsider" stockholders.
C) stock in the company is very diffusely held, with no individual or group having control over a large block of stock.
D) managers have profit-sharing schemes as part of their incentive package.
E) managers focus on maximizing the firm's profits, rather than the firm's market share.

Question 78

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. If a fixed wage of $3000 is given the individual worker, the result will be

A) low effort 75% of the time.
B) low effort 25% of the time.
C) low effort.
D) high effort.
E) high or low effort depending on whether the worker thinks the $3000 is an acceptable wage.

Question 79

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

A) $5,000.
B) $10,000.
C) $100,000.
D) $200,000.
E) $1,000,000.

Question 80

The principal-agent problem of ownership vs. control of the corporation arises when owners and managers

A) are the same people.
B) pursue objectives that differ from those their customers wish them to pursue.
C) pursue objectives that differ from those their workers wish them to pursue.
D) pursue objectives that differ from those the government wishes them to pursue.
E) pursue different objectives.