CHAPTER 38: Asymmetric Information
TRUE/FALSE
1. An insurance company must be concerned about the possibility that someone will buy fire insurance
on a building and then set fire to it. This is an example of moral hazard.
2. A life insurance company must be concerned about the possibility that the people who buy life
insurance may tend to be less healthy than those who do not. This is an example of adverse selection.
3. In a market where there is signaling, a separating equilibrium occurs when economic agents separate
their actions as consumers from their actions as producers.
4. In a market where there is a separating equilibrium, different types of agents make different choices of
actions.
5. In a market where there is a pooling equilibrium, different types of agents choose the same action.
6. The incentive compatibility constraint requires that incentives be consistent with a consumers budget
constraint.
7. An example of adverse selection is the situation where someone chooses a car that is not as good as it
is claimed to be.
MULTIPLE CHOICE
1. A firm hires two kinds of workers, alphas and betas. The population at large has equal number of
alphas and betas. One can’t tell a beta from an alpha by looking at her, but an alpha will produce
$3,000 worth of output per month and a beta will produce $2,500 worth of output in a month. The firm
decides to distinguish alphas from betas by having workers take an examination. A worker will be paid
$3,000 if she gets at least 60 answers right and $2,500 otherwise. For each question that they get right
on the exam, alphas have to spend 1/2 hour studying and betas have to spend 1 hour. For either type,
an hour’s studying is as bad as giving up $20 of income per month. This scheme leads to
a.
a separating equilibrium where alphas score 60 and betas score 0.
b.
a pooling equilibrium where alphas score 60 and betas score 0.
c.
a pooling equilibrium where everybody scores 60.
d.
a pooling equilibrium where everybody scores 0.
e.
a separating equilibrium where everybody scores 60.
2. Ten workers work jointly on a project. All 10 workers are equally skilled. The total value of the output
produced is $70 times the sum of the number of hours worked by all 10 workers. Each worker’s utility
is equal to his income minus the square of the number of hours he works. Each worker is selfish. The
employers have no way of keeping track of any individual’s work effort, so they decide to let each
person work as long as he wants to and they divide the total value of the output equally among the
workers. How much income will each worker get?
a.
$245
b.
$2,450
c.
$35
d.
$260
e.
None of the above.
3. Ten workers work jointly on a project. All 10 workers are equally skilled. The total value of the output
produced is $60 times the sum of the number of hours worked by all 10 workers. Each worker’s utility
is equal to his income minus the square of the number of hours he works. Each worker is selfish. The
employers have no way of keeping track of any individual’s work effort, so they decide to let each
person work as long as he wants to and they divide the total value of the output equally among the
workers. How much income will each worker get?
a.
$1,800
b.
$180
c.
$30
d.
$195
e.
None of the above.
4. Ten workers work jointly on a project. All 10 workers are equally skilled. The total value of the output
produced is $90 times the sum of the number of hours worked by all 10 workers. Each worker’s utility
is equal to his income minus the square of the number of hours he works. Each worker is selfish. The
employers have no way of keeping track of any individual’s work effort, so they decide to let each
person work as long as he wants to and they divide the total value of the output equally among the
workers. How much income will each worker get?
a.
$420
b.
$45
c.
$405
d.
$4,050
e.
None of the above.
5. Which of the following is the best example of adverse selection?
a.
People who face the highest risks are the people most likely to buy insurance against these
risks.
b.
The residual claimant will have to bear the consequences of the most adverse outcomes.
c.
An individual can influence the probability that she has an accident.
d.
Items in the most popular styles sell out the quickest.
e.
People sometimes mistakenly choose low-quality products.
6. A certain city has two kinds of workers, alphas and betas. An alpha can produce $100 worth of output
per day working for himself. If he works in the local factory, he produces $120 worth of output a day.
A beta produces $60 worth of output per day working for himself, and he produces $80 worth of
output per day if he works for the local factory. Workers either work for themselves or work in the
factory. The factory owner can’t tell alphas from betas. He pays a wage equal to the average product of
his labor force and he has at least some alphas working for him. Workers are free to choose to work for
themselves or the factory, depending on which offers more money.
a.
At least 5/6 of the factory’s employees must be alphas.
b.
At least half of the factory’s employees must be betas.
c.
At least half of the factory’s employees must be alphas.
d.
None of the factory’s employees can be betas.
e.
No more than 5/6 of the betas can work in the factory.
7. Enigma, Ohio, has two kinds of workers, klutzes whose labor is worth $1,000 a month and kandos
whose labor is worth $2,500 a month. Enigma has exactly twice as many klutzes as kandos. Klutzes
look just like kandos and are accomplished liars, so if you ask, they claim to be kandos. It is too
expensive to monitor anybody’s work. A professor who likes to talk offers to give free lectures on
personal hygiene and macroeconomics. Klutzes and kandos find these lectures excruciatingly dull. An
hour’s lecture is as bad as losing $50 for a kando and as bad as losing $100 for a klutz. If all other
firms pay wages equal to the productivity of an average citizen of Enigma, which of these strategies
would be most profitable for a new firm?
a.
Offer a wage of $2,000 per month and require its workers to listen to 6 hours of lectures
per month.
b.
Offer a wage of $2,000 per month and require its workers to listen to 4 hours of lectures
per month.
c.
Offer a wage of $1,750 per month and require its workers to listen to 6 hours of lectures
per month.
d.
Offer a wage of $1,660 per month and require its workers to attend 1 hour of lectures per
month.
e.
Offer a wage of $2,600 per month and require its workers to attend 8 hours of lectures per
month.
8. Jan’s utility function is C − H2, where C is consumption and H is hours worked per day. She can work
in the city for 8 hours per day, earning $100 a day. Alternatively, she can rent a small farm from Mr.
Porksniffer. If she rents the farm, she can work as many hours a day as she wishes. If she works H
hours per day, she can sell her crops for a total of $20H per day, but she must pay Mr. Porksniffer an
annual rent of $R. Mr. Porksniffer wants to charge the highest rent $R that he can and still be able to
have Jan rent from him. What is the highest rent he can charge? A penny less than
a.
$100 per day.
b.
$64 per day.
c.
$60 per day.
d.
$50 per day.
e.
$36 per day.
9. Suppose that low-productivity workers all have marginal products of 10 and high-productivity workers
have marginal products of 16. The community has equal numbers of each type of worker. The local
community college offers a course in microeconomics. High-productivity workers think taking this
course is as bad as a cut in wages of $4 and low-productivity workers think it is as bad as a wage cut of
$8.
a.
There is a separating equilibrium in which high-productivity workers take the course and
are paid $16 and low-productivity workers do not take the course and are paid $10.
b.
There is no separating equilibrium and no pooling equilibrium.
c.
There is no separating equilibrium, but there is a pooling equilibrium in which everybody
is paid $13.
d.
There is a separating equilibrium in which high-productivity workers take the course and
are paid $20 and low-productivity workers do not take the course and are paid $10.
e.
There is a separating equilibrium in which high-productivity workers take the course and
are paid $16 and low-productivity workers are paid $13.
10. Suppose that low-productivity workers all have marginal products of 10 and high–productivity workers
have marginal products of 16. The community has equal numbers of each type of worker. The local
community college offers a course in microeconomics. High-productivity workers think taking this
course is as bad as a cut in wages of $5 and low-productivity workers think it is as bad as a wage cut of
$9.
a.
There is no separating equilibrium, but there is a pooling equilibrium in which everybody
is paid $13.
b.
There is a separating equilibrium in which high-productivity workers take the course and
are paid $16 and low-productivity workers do not take the course and are paid $10.
c.
There is a separating equilibrium in which high-productivity workers take the course and
are paid $21 and low-productivity workers do not take the course and are paid $10.
d.
There is no separating equilibrium and no pooling equilibrium.
e.
There is a separating equilibrium in which high-productivity workers take the course and
are paid $16 and low-productivity workers are paid $13.
11. Suppose that low-productivity workers all have marginal products of 10 and high–productivity workers
have marginal products of 16. The community has equal numbers of each type of worker. The local
community college offers a course in microeconomics. High-productivity workers think taking this
course is as bad as a cut in wages of $5 and low-productivity workers think it is as bad as a wage cut of
$9.
a.
There is no separating equilibrium and no pooling equilibrium.
b.
There is no separating equilibrium, but there is a pooling equilibrium in which everybody
is paid $13.
c.
There is a separating equilibrium in which high- productivity workers take the course and
are paid $21 and low-productivity workers do not take the course and are paid $10.
d.
There is a separating equilibrium in which high- productivity workers take the course and
are paid $16 and low-productivity workers do not take the course and are paid $10.
e.
There is a separating equilibrium in which high- productivity workers take the course and
are paid $16 and low-productivity workers are paid $13.
12. Suppose that in Enigma, Ohio, klutzes have a productivity of $1,000 and kandos have a productivity of
$4,000 per month. You can’t tell klutzes from kandos by looking at them or asking them, and it is too
expensive to monitor individual productivity. Kandos, however, have more patience than klutzes.
Listening to an hour of dull lectures is as bad as losing $250 for a klutz and $100 for a kando. There
will be a separating equilibrium in which anybody who attends a course of H hours of lectures is paid
$4,000 per month and anybody who does not is paid $1,000 per month
a.
if 12 H 30.
b.
if 12 H 60.
c.
for all positive values of H.
d.
only in the limit as H approaches infinity.
e.
if 10 H 25.
13. Suppose that in Enigma, Ohio, klutzes have a productivity of $1,000 and kandos have a productivity of
$5,000 per month. You can’t tell klutzes from kandos by looking at them or asking them, and it is too
expensive to monitor individual productivity. Kandos, however, have more patience than klutzes.
Listening to an hour of dull lectures is as bad as losing $250 for a klutz and $100 for a kando. There
will be a separating equilibrium in which anybody who attends a course of H hours of lectures is paid
$5,000 per month and anybody who does not is paid $1,000 per month
a.
if 16 H 80.
b.
if 16 H 40.
c.
only in the limit as H approaches infinity.
d.
for all positive values of H.
e.
if 14 H 35.
14. Suppose that in Enigma, Ohio, klutzes have a productivity of $1,000 and kandos have a productivity of
$5,000 per month. You can’t tell klutzes from kandos by looking at them or asking them, and it is too
expensive to monitor individual productivity. Kandos, however, have more patience than klutzes.
Listening to an hour of dull lectures is as bad as losing $250 for a klutz and $150 for a kando. There
will be a separating equilibrium in which anybody who attends a course of H hours of lectures is paid
$5,000 per month and anybody who does not is paid $1,000 per month
a.
only in the limit as H approaches infinity.
b.
if 16 H 53.33.
c.
for all positive values of H.
d.
if 16 H 26.67.
e.
if 14 H 23.33.
15. In Rustbucket, Michigan, there are 200 used cars for sale; half of these cars are good and half of them
are lemons. Owners of lemons are willing to sell them for $100. Owners of good used cars are willing
to sell them for prices above $1,500 but will keep them if the price is lower than $1,500. There is a
large number of potential buyers who are willing to pay $300 for a lemon and $1,900 for a good car.
Buyers can’t tell good cars from bad, but original owners know.
a.
There will be an equilibrium in which all used cars sell for $1,100.
b.
The only equilibrium is one in which all used cars on the market are lemons and they sell
for $300.
c.
There will be an equilibrium in which lemons sell for $100 and good used cars sell for
$1,500.
d.
There will be an equilibrium in which all used cars sell for $800.
e.
There will be an equilibrium in which lemons sell for $300 and good used cars sell for
$1,900.
16. In Rustbucket, Michigan, there are 200 used cars for sale; half of these cars are good and half of them
are lemons. Owners of lemons are willing to sell them for $500. Owners of good used cars are willing
to sell them for prices above $1,300 but will keep them if the price is lower than $1,300. There is a
large number of potential buyers who are willing to pay $600 for a lemon and $2,300 for a good car.
Buyers can’t tell good cars from bad, but original owners know.
a.
There will be an equilibrium in which lemons sell for $500 and good used cars sell for
$1,300.
b.
There will be an equilibrium in which all used cars sell for $1,450.
c.
The only equilibrium is one in which all used cars on the market are lemons and they sell
for $600.
d.
There will be an equilibrium in which all used cars sell for $900.
e.
There will be an equilibrium in which lemons sell for $600 and good used cars sell for
$2,300.
17. In Rustbucket, Michigan, there are 200 used cars for sale; half of these cars are good and half of them
are lemons. Owners of lemons are willing to sell them for $500. Owners of good used cars are willing
to sell them for prices above $1,100 but will keep them if the price is lower than $1,100. There is a
large number of potential buyers who are willing to pay $600 for a lemon and $1,700 for a good car.
Buyers can’t tell good cars from bad, but original owners know.
a.
There will be an equilibrium in which all used cars sell for $800.
b.
There will be an equilibrium in which lemons sell for $500 and good used cars sell for
$1,100.
c.
There will be an equilibrium in which all used cars sell for $1,150.
d.
The only equilibrium is one in which all used cars on the market are lemons and they sell
for $600.
e.
There will be an equilibrium in which lemons sell for $600 and good used cars sell for
$1,700.
18. Suppose that in New Crankshaft, Pennsylvania, the quality distribution of the 8,000 used cars on the
market is such that the number of used cars of value less than V is V/2. Original owners must sell their
used cars. Original owners know what their cars are worth, but buyers can’t determine a car’s quality
until they buy it. An owner can either take his car to an appraiser and pay the appraiser $100 to
appraise the car (accurately and credibly) or sell the car unappraised. In equilibrium, car owners will
have their cars appraised if and only if the car’s value is at least
a.
$100.
b.
$4,000.
c.
$300.
d.
$200.
e.
$400.
19. Suppose that in New Crankshaft, Pennsylvania, the quality distribution of the 6,000 used cars on the
market is such that the number of used cars of value less than V is V/2. Original owners must sell their
used cars. Original owners know what their cars are worth, but buyers can’t determine a car’s quality
until they buy it. An owner can either take his car to an appraiser and pay the appraiser $400 to
appraise the car (accurately and credibly) or sell the car unappraised. In equilibrium, car owners will
have their cars appraised if and only if the car’s value is at least
a.
$1,200.
b.
$3,000.
c.
$400.
d.
$800.
e.
$1,600.
20. Suppose that in New Crankshaft, Pennsylvania, the quality distribution of the 4,000 used cars on the
market is such that the number of used cars of value less than V is V/2. Original owners must sell their
used cars. Original owners know what their cars are worth, but buyers can’t determine a car’s quality
until they buy it. An owner can either take his car to an appraiser and pay the appraiser $100 to
appraise the car (accurately and credibly) or sell the car unappraised. In equilibrium, car owners will
have their cars appraised if and only if the car’s value is at least
a.
$2,000.
b.
$100.
c.
$300.
d.
$200.
e.
$400.
21. There are two types of used cars, high quality and low quality. Buyers cannot distinguish the two types
until after they have purchased them. Owners of high-quality cars will sell them if the price is $2,000
or higher. Owners of low-quality cars will sell them if the price is $1,000 or higher. Buyers value a
high-quality used car at $4,266 and a low-quality used car at $1,200. Suppose that 30% of used cars
are of high quality and 70% of used cars are of low quality. In equilibrium,
a.
only high-quality used cars will be sold.
b.
only low-quality used cars will be sold.
c.
all used cars will be sold.
d.
no used cars will be sold.
e.
high-quality used cars will sell for a uniformly higher price than low-quality used cars.
22. There are two types of used cars, high quality and low quality. Buyers cannot distinguish the two types
until after they have purchased them. Owners of high-quality cars will sell them if the price is $2,000
or higher. Owners of low-quality cars will sell them if the price is $1,000 or higher. Buyers value a
high-quality used car at $3,466 and a low-quality used car at $1,200. Suppose that 30% of used cars
are of high quality and 70% of used cars are of low quality. In equilibrium,
a.
all used cars will be sold.
b.
only low-quality used cars will be sold.
c.
no used cars will be sold.
d.
only high-quality used cars will be sold.
e.
high-quality used cars will sell for a uniformly higher price than low-quality used cars.
23. There are two types of used cars, high quality and low quality. Buyers cannot distinguish the two types
until after they have purchased them. Owners of high-quality cars will sell them if the price is $2,000
or higher. Owners of low-quality cars will sell them if the price is $1,000 or higher. Buyers value a
high-quality used car at $1,942 and a low-quality used car at $1,200. Suppose that 70% of used cars
are of high quality and 30% of used cars are of low quality. In equilibrium,
a.
only low-quality used cars will be sold.
b.
only high-quality used cars will be sold.
c.
no used cars will be sold.
d.
all used cars will be sold.
e.
high-quality used cars will sell for a uniformly higher price than low-quality used cars.
PROBLEM
1. Lexus has recently begun a program in which a used Lexus automobile which passes a 100+ point
inspection is designated by the local dealer to be a Lexus Certified Pre-owned Vehicle. Would local
Lexus dealers find it in their best interest to participate? Explain.