1. The principal is distinct from the agent in the principal-agent model because
a.
the principal offers the contract to the agent.
b.
the principal is fully informed.
c.
both a and b.
d.
neither a nor b.
2. Which of the following is an application of the adverse-selection problem?
a.
a customer driving more recklessly after buying car insurance.
b.
a teenager “hanging out” with friends his or her parents do not approve of.
c.
shareholders offering a high-powered incentive contract to a manager.
d.
an auto repairman claiming that the repairs are more extensive than they actually are.
d
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3. Adverse selection arises in insurance markets because
a.
insurance buyers have more information than insurance sellers.
b.
insurance sellers have more information than insurance buyers.
c.
individuals can select which insurance company to patronize.
d.
insurance companies can exercise too much control over whom they insure.
a
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4. Adverse selection in competitive insurance markets harms
a.
b.
c.
d.
b
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5. An example of adverse selection is
a.
purchasing a new car sight unseen based on the recommendation of a neighbor.
b.
high health-insurance premiums resulting from the poor health of people who buy policies.
c.
suppliers who charge more for better quality clothing than for lower quality clothing.
d.
being talked into buying a low-quality item because the price is lower.
b
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6. Which of the following is an application of the moral-hazard problem?
a.
a person buying insurance after a cancer diagnosis.
b.
an salesperson who is not paid on commission being rude to customers.
c.
coffee hounds buying the menu item meant for lower-demand consumers.
d.
only inexperienced workers applying for a managerial job advertised with a relatively low salary.
b
a
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7. A risk-averse manager is hired to run a firm for shareholders. If the manager’s effort can be observed and specified in a
contract, which would be the best employment contract?
a.
a high-powered incentive contract to elicit the most effort.
b.
a fixed salary paid as long as the required effort is undertaken.
c.
a proportion of profits paid as long as the required effort is undertaken.
d.
a wage well in excess of his or her outside opportunity.
b
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8. A risk-averse manager is hired to run a firm for shareholders. If shareholders cannot observe the manager’s effort,
which would be the best employment contract?
a.
a high-powered incentive contract to elicit maximum effort.
b.
a fixed salary.
c.
a moderately powered incentive scheme that elicits some effort without exposing the manager to too much
risk.
d.
an incentive scheme that provides maximum incentives and maximum insurance.
c
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9. Given a series of contracts offered to an executive having the same slope (where slope refers to how the contract varies
with changes in the firm’s gross profits) but different intercepts (referring to the overall generosity of the contract).
Which of these is not a consideration in figuring out which of these intercepts the shareholders would decide to build into
the contract offered to the executive?
a.
if too generous a contract is offered, this comes out of the firm’s bottom-line profit.
b.
if too generous a contract is offered, the executive may become lazy and not exert the required effort.
c.
if the contract isn’t generous enough, the executive will decide to work elsewhere.
d.
if the contract isn’t generous enough, only low-ability executives will apply.
b
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10. Which are social costs associated with the inability of shareholders to observe an executive’s effort? (You may
choose more than one.)
a.
Excessive insurance offered.
b.
The executive has to be exposed to risk to induce effort, and risk is costly.
c.
The executive ends up exerting less than first-best effort.
d.
Excessive effort induced.
b, c
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11. A monopoly coffee shop is deciding on a menu of different cup sizes to sell to a population of consumers, some of
whom are high demanders and some low demanders. How would the optimal menu differ depending on whether the
consumers can be observably separated into the different types or not?
a.
The menu is unaffected by type observability.
b.
If types aren’t observable, the large cup size should be increased to separate the high demander.
c.
If types aren’t observable, the small cup size should be increased to make it more attractive to low demanders.
d.
If types aren’t observable, the small cup size should be reduced to make it less attractive to high demanders.
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12. How is it logically possible for a monopolist to get different consumers to purchase different bundles on a menu (such
as different sizes of coffee cups), and thereby achieve a form of price discrimination, even if the firm cannot observe the
consumers’ valuations directly?
a.
Different types of consumers have different tradeoffs between money and amounts of the good.
b.
The monopolist can use a market-separation strategy.
c.
Social norms are powerful deterrents to lying about one’s type.
d.
This is impossible: if one bundle is preferred by one type, logically it will be preferred by all.
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13. Which is a distortion (a loss of social surplus) associated with a monopolist’s inability to observe consumer types
when constructing a nonlinear pricing scheme?
a.
The monopolist must expend more resources on market research.
b.
All bundles involve inefficiently low quantities.
c.
Some but not all bundles involve inefficiently low quantities.
d.
Quantities aren’t distorted, but prices extract too much consumer surplus.
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14. Which of the following are potential problems faced by a firm that wants to provide warranties for its lawnmowers?
(Select all that apply.)
a.
A moral hazard problem might arise, in that homeowners may be less careful with the mower, since they can
always return it if it breaks.
b.
The warranty may select for homeowners that don’t have a lot of mowing to do, or have smooth lawns,
because they won’t have to pay as much for a warranty.
c.
The warranty will increase demand by assuring customers of the product’s quality.
d.
The warranty will reduce demand because only makers of low-quality goods would need to reassure
consumers in this way.
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15. Concerning auctions, what is the definition of a “common-values setting”?
a.
Bids are submitted using open outcries.
b.
Bids are submitted simultaneously, and the highest is selected as the winner.
c.
Bidders value the object the same, but are uncertain as to what that value is.
d.
Bids are submitted by syndicates of cooperating bidders.
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16. Which auction format generates the most revenue for the seller?
a.
First price.
b.
Second price.
c.
They generate the same expected revenue.
d.
Depends on the environment.
d
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17. Suppose that your personal valuation for a painting is $200. Which auction format would induce you to bid more?
a.
First price.
b.
Second price.
c.
You would bid the same in any format.
d.
Depends on the environment.
b
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18. How do participants in an auction respond to the problem of the “winner’s curse”?
a.
They bid more aggressively to win the auction and avoid the “curse”.
b.
They exit the auction because winning can only be a bad sign of the object’s worth.
c.
All bid less aggressively, so that the winner ends up not regretting having won.
d.
The winner regrets having won the auction.
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19. In the Spence education signaling model, what is the social value of education?
a.
Employees improve their ability to perform on the job.
b.
Employers can use education as a screen to match talented employees with high-skill jobs.
c.
Employers can save the costs of on-the-job training, which is less efficient than a general education.
d.
It allows low-ability employees to apply for high-salary jobs.
b
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20. One way the “lemons problem” in the used-car market can be mitigated is by
a.
raising the price of used cars.
b.
hiring auto experts to sell used cars.
c.
requiring sellers to guarantee trouble-free cars.
d.
allowing owners to trade in their own cars when they purchase a used car.
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21. The “lemons model” predicts quality deterioration in the used-car market because
a.
used cars require increasing maintenance.
b.
suppliers and demanders have different information about cars’ quality.
c.
used cars are generally of a lower quality than new cars.
d.
people will usually buy new cars if they are available.
b
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22. A market characterized by asymmetric information will have an equilibrium price if at that price
a.
quantity demanded equals quantity supplied when all participants have the same information.
b.
quantity demanded equals quantity supplied given prevailing information levels.
d
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c.
quantity demanded equals quantity supplied under perfect information.
d.
quantity demanded exceeds quantity supplied if suppliers are better informed (and vice versa).
23. A ready-to–eat cereal manufacturer faces two types of consumers, adults and children, having the following schedule
of gross surpluses for each additional unit of cereal consumed.
Marginal
Marginal
surplus
surplus
this ounce
this ounce
provides
provides
Ounce of
adults in
children
cereal
cents
in cents
First
20
40
Second
16
32
Third
12
24
Fourth
8
16
Fifth
4
8
Sixth
0
0
Seventh
0
0
Cereal costs 10 cents per ounce to produce. Begin by assuming that the manufacturer has full information about types
because adults only by fiber-rich cereal and children only buy sweet cereal (with marshmallows).
a.
3 ounces of fiber cereal sold to adults for 48 cents; 4 ounces of sweet cereal sold to children for $1.12.
b.
3 ounces of fiber cereal sold to adults for 36 cents; 4 ounces of sweet cereal sold to children for 64 cents.
c.
5 ounces of fiber cereal sold to adults for 60 cents; 5 ounces of sweet cereal sold to children for $1.20.
d.
5 ounces of fiber cereal sold to adults for 20 cents; 5 ounces of sweet cereal sold to children for 40 cents.
a
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24. Return to the ready-to–eat cereal example from the previous question. Now assume that there is only one kind of
cereal, so the manufacturer cannot distinguish between types of consumer (adults vs. children, of which suppose there are
equal numbers in the market). What is the optimal menu of cereal boxes?
a.
a 3 ounce box (which adults will buy) sold for 48 cents; a 4 ounce box (which children will buy) sold for
$1.12.
b.
a 3 ounce box (which adults will buy) sold for 48 cents; a 4 ounce box (which children will buy) sold for 64
cents.
c.
a 2 ounce box (which adults will buy) sold for 36 cents; a 4 ounce box (which children will buy) sold for 76
cents.
d.
No menu; the manufacturer is better off just selling a 5 ounce box for $1.12, which is only purchased by
children.
d
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25. A executive can either slack (effort e = 0) or work hard (e = 1) on behalf of shareholders. If she slacks, the firm earns
a gross return of 1,000 for sure. If she works hard, there is an even chance of the gross return being 10,000 or 80,000.
Her overall utility equals her utility from wage income (of the form w1/2, where w is the wage) minus the disutility of
work (simply d), or in other words U = w1/2 – d. If she slacks, she experiences no disutility of work (d = 0) but if she
works hard, the disutility of work is d = 50. Assume that U = 0 in her next best available job. What is the optimal wage
contract that shareholders would offer if they can observe the effort of the executive?
a.
A flat wage w = 0 and no requirement to work hard.
b
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b.
A flat wage w = 50 and a requirement to work hard.
c.
A flat wage w = 2,500 and a requirement to work hard.
d.
A share of 50% of the profits and a requirement to work hard.
26. Return to the situation with the executive from the previous question. Now assume that shareholders cannot observe
effort, so cannot specify how hard the executive works in the contract but must induce it through the incentive scheme.
Which of the following wage contracts would work out best for shareholders in equilibrium?
a.
A flat wage w = 2,500 with no profit share.
b.
A share of 35% of the gross profits.
c.
A share of 55% of the gross profits.
d.
A share of 70% of the gross profits.
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27. There are two types of worker, high ability and low ability. High-ability workers generate gross profit of A on the job
and low-ability generate nothing. Education does not make workers more productive, but is costly to obtain (cH for high
ability workers and cL for low ability ones). Let w be the wage that all firms in the economy pay by regulatory mandate.
Suppose the worker obtains utility given by the wage (if the worker is employed, 0 if not) minus the cost of education (if
any). There is no disutility from work. Which condition is required if only the high-ability type is to obtain an education
in equilibrium?
a.
cH < w < cL.
b.
cL < w < cH.
c.
cH < cL < w.
d.
cL < cH < w.
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28. Return to the case of education and the job market from the previous question. Which condition would be consistent
with both types’ obtaining an education in equilibrium?
a.
cH < w < cL.
b.
cL < w < cH.
c.
cH < cL < w.
d.
w < cL < cH.
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