Chapter 17 - Asymmetric Information

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.

C

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.

D

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.

B

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 personʹs 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 doesnʹt have health insurance already, he will not be able to get it.

B

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.

E

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.

D

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

C

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.

C

Assume that a particular state has decided to outlaw the sharing of individualsʹ 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

D

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

E

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.

B

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 ʺselecting out,ʺ to the detriment of low-risk drivers.

E) increases the amount of information available to insurers about the population.

C

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 ʺselecting out,ʺ to the detriment of healthy people.

E) increases the amount of information available to insurers about the population.

C

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.

A

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.

A

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

A) quality.

B) government regulation.

C) reputation of individual sellers.

D) firmsʹ distinguishing among buyers.

E) firmsʹ segregation of buyers.

C

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

D

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.

D

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

B

If grades are to be a successful signal to potential employers of a studentʹs 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.

A

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 donʹt.

E

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.

A

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.

A

Which of the following is TRUE about producersʹ 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 wouldnʹt 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 ʺimpartialʺ view of the product is given to the consumer.

E) Producers will not offer warranties in any market that suffers from asymmetric

information.

C

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) isnʹt 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.

A

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.

B

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.

C

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

A

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.

B

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

A

In the insurance market, ʺmoral hazardʺ refers to the problem that

A) insurers canʹt 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.

E

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 driverʹs seat belt 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.

C

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.

A

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.

C

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 ʺdepositor moral hazardʺ but did not involve a moral hazard problem with owners.

D) contributed to ʺmoral hazard by ownersʺ but did not involve a moral hazard problem with depositors.

E) contributed to both ʺdepositor moral hazardʺ and ʺmoral hazard by owners.ʺ

E

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.

D

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

B

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.

D

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 firmʹs avoiding moral hazard problems.

D) are generally unable to do the monitoring that would result in the firmʹs avoiding adverse selection.

E) are generally unable to monitor workers, who do not care about the profits due the managers.

A

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

A) The corporationʹs growth

B) Increased market share for the corporation

C) The maximum possible profit for the corporation D) A great ʺgolden parachuteʺ or retirement package

E) Increased current salary and fringe benefits

C

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.

E

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 companyʹs day-to-day operations.

B) stock in the company is tightly held, but there are some ʺoutsiderʺ 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 firmʹs profits, rather than the firmʹs market share.

C

In the economic literature on principal-agent problems, the __________ is the person who takes some action, and the __________ is the person whom the action affects.

A) agent, principal

B) principal, agent

C) Both statements describe the agent.

D) Both statements describe the principal.

A

Suppose Bob owns two factories that are located several hundred miles apart. Bob decides to manage one of the plants himself, and he hires another person to manage the second plant. For purposes of operating the second plant, who is the agent and who is principal?

A) Bob is the agent and the manager is the principal.

B) Bob is the principal and the manager is Bobʹs agent.

C) Both Bob and the manager are principals.

D) We need more information to determine the identities of the principal and the agent in

this case.

B

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 principalʹs fundamental inability to oversee or supervise the agent.

A) I and II are true.

B) I is true and II is false.

C) II is true and I is false.

D) I and II are false.

C

Asymmetric information problems arise

A) in horizontally integrated firms, but not vertically integrated firms.

B) in vertically integrated firms, but not horizontally integrated firms.

C) in both vertically and horizontally integrated firms.

D) only in firms that do not have the advantage of either horizontal or vertical integration.

E) only when a single firm is both horizontally and vertically integrated.

C

What is the problem with paying plant managers in multi-plant firms according to the level of output they produce?

A) Managers in low-cost or high-capacity plants could be penalized, in percentage terms, for their overproduction.

B) The production problem in multi-plant firms is usually how to lower production to increase market power, not how to increase production.

C) Managers in high-cost or low-capacity plants could be penalized for production constraints over which they have no control.

D) Managers would have an incentive to understate the productive capacity of their plants.

E) Managers would have an incentive to overstate the productive capacity of their plants.

C

What is the problem with paying plant managers in multi-plant firms according to how much each plant produces relative to its capacity?

A) Managers in low-cost or high-capacity plants could be penalized, in percentage terms, for their overproduction.

B) The production problem in multi-plant firms is usually how to lower production to increase market power, not how to increase production.

C) Managers in high-cost or low-capacity plants could be penalized for production constraints over which they have no control.

D) Managers would have an incentive to understate the productive capacity of their plants.

E) Managers would have an incentive to overstate the productive capacity of their plants.

D

The problem of asymmetric information in multi-plant firms involves

A) only the problem of how to get managers to produce as much as possible.

B) only the problem of how to get managers to produce the amount the larger firm wants them to, whether it be a lot or a little.

C) both the problem of how to get managers to produce the appropriate amount and the problem of how to get them to accurately report their capacity.

D) both the problem of how to get managers to produce the appropriate amount and the problem of how to get them to not sell that output outside of the firm.

E) both the problems of vertical and horizontal integration with the rest of the firm.

C

The problem of production in multi-plant firms with asymmetric information can be solved by paying the manager

A) a piece rate, some constant amount per unit of output produced.

B) a larger amount for each unit than was paid for the previous unit, to reflect increasing

marginal cost.

C) a smaller amount for each unit than was paid for the previous unit, to reflect decreasing

marginal revenue.

D) an annual bonus that increases with each unit of output up to capacity, and decreases

with each unit of output past capacity.

E) an annual bonus that is calculated decreases with each unit of output up to capacity, and

increases with each unit of output past capacity.

D

The ʺefficiency wageʺ is the wage at which

A) employees have no incentive to shirk.

B) employees have an incentive to do the optimal (positive) amount of shirking.

C) the cost of looking for work is equal to the value of the leisure time for the unemployed

individual.

D) there is no unemployment.

E) there is only frictional unemployment.

A

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

A) no unemployment exists, and workers have no incentive to shirk.

B) no unemployment exists, and workers have an incentive to shirk.

C) some unemployment still exists, but workers have no incentive to shirk.

D) some unemployment still exists, but managers can tell whether or not workers are

shirking.

B

The efficiency wage is

A) lower than the market-clearing wage, to penalize shirking.

B) higher than the market-clearing wage, to penalize shirking.

C) lower than the market-clearing wage, to allow managers the resources to monitor

shirking.

D) higher than the market-clearing wage, to reward workers for informing on others who

shirk.

E) lower than the market-clearing wage, because of shirking done by managers.

B

The efficiency wage is

A) a wage at which there is no unemployment, and shirking workers are not counted in the

pool of total labor.

B) a wage at which there is a positive amount of unemployment. Individuals who are fired

for shirking will be penalized with a period of unemployment.

C) a wage at which there is a shortage of labor. Firms who fire a worker for shirking will be

able to hire another one easily.

D) the wage that is paid to high-quality, non-shirking workers. Other workers are paid the

market-clearing wage.

E) the wage that subtracts the cost of shirking from the market-clearing wage to determine

that which is really paid.

B

Suppose new electronic devices make it easier to monitor the effort levels of workers. If some shirking is still possible in the efficiency wage model, what happens to the efficiency wage?

A) Declines, but remains above the competitive wage

B) Declines, and falls below the competitive wage

C) Increases

D) Does not change

A

Suppose new electronic devices make it easier to monitor the effort levels of workers. If some shirking is still possible in the efficiency wage model, what happens to the level of unemployment?

A) Increases, but some unemployment remains

B) Increases, and the labor market reaches full employment

C) Decreases

D) Does not change

A

Use the following statements to answer this question:

I. Efficiency wage theory was developed to help explain persistent unemployment and wage discrimination in labor markets.

II. Efficiency wage theory recognizes that labor productivity may be affected by the wage rate.

A) I and II are true.

B) I is true and II is false.

C) II is true and I is false.

D) I and II are false.

A

Ford Motor Company was one of the first major companies to adopt a wage structure that is comparable to efficiency wages. What was the outcome of Fordʹs experiment with efficiency wages?

A) Lower labor force turnover

B) Higher labor productivity

C) Less absenteeism

D) all of the above

D