978-1259723223 Chapter 4A

Chapter 04 Appendix

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Chapter 04 Appendix

McConnell Brue Flynn 21e

APPENDIX DISCUSSION QUESTIONS

1. Because medical records are private, an individual applying for health insurance will know

more about his own health conditions than will the insurance companies to which he is applying

for coverage. Is this likely to increase or decrease the insurance premium that he will be offered?

Why? LO6

Answer: This will likely increase the insurance premium because the buyers of the

insurance policy have more information about their health status than the sellers (the

2. Why is it in the interest of new homebuyers and builders of new homes to have government

building codes and building inspectors? LO6

Answer: The reason is related to the lack of information and education on the part of

most new homebuyers and builders with regard to every aspect of home construction. To

3. Place an “M” beside the items in the following list that describe a moral hazard problem and an

“A” beside those that describe an adverse selection problem. LO6

a. A person with a terminal illness buys several life insurance policies through the mail.

b. A person drives carelessly because she has automobile insurance.

c. A person who intends to torch his warehouse takes out a large fire insurance policy.

d. A professional athlete who has a guaranteed contract fails to stay in shape during the off–

season.

e. A woman who anticipates having a large family takes a job with a firm that offers exceptional

childcare benefits.

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consent of McGraw-Hill Education.

Answer: (a) This is an adverse selection problem. The buyer of the insurance policy has

more information about his or her health than the seller when the contract is signed.

(b) This is a moral hazard problem. The person changes their behavior after the insurance

contract is signed.

(c) This is an adverse selection problem. The buyer of the insurance policy has more

information about the likelihood of a fire (intentional) than the seller when the contract is

signed.

(d) This is a moral hazard problem. The person changes his or her behavior after the

contract is signed.

(e) This is an adverse selection problem. The woman has more information about her

desired family size when the firm hires her.

APPENDIX REVIEW QUESTIONS

1. People drive faster when they have auto insurance. This is an example of: LO6

a. Adverse selection.

b. Asymmetric information.

c. Moral hazard.

2. Government inspectors who check on the quality of services provided by retailers as

well as government requirements for licensing in various professions are both attempts to

resolve: LO6

a. The moral hazard problem.

b. The asymmetric information problem.

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3. True or False: A market may collapse and have relatively few transactions between buyers and

sellers if buyers have more information than sellers. LO6

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consent of McGraw-Hill Education.

Answer: True

This statement is true because when buyers have more information than sellers, sellers

must worry that buyers will take advantage of them. The standard example of this

phenomenon is health insurance, because individuals almost always have better

information about their own health conditions than insurance companies. This causes a

pricing problem for the insurance companies, who would like to keep the cost of

insurance low so that it will be widely popular with all sorts of people. But the people

most likely to want to buy health insurance are people who know that they are sicker than

average and will very likely need a lot of costly treatments in the future.

Taking that into consideration, the health insurance companies must raise the price of

insurance so as to make sure that they will be collecting enough in premiums to be able to

cover those high future costs. But as the price of insurance rises, a lot of healthy people

will no longer find it worth their while to buy health insurance. As they drop out of the

market, the group of people still buying insurance comes to be dominated by the people

who privately know that they are more costly than average. As a result, the market may

collapse as many who would have bought insurance at lower prices now choose to go

without.

APPENDIX PROBLEMS

1. Consider a used-car market with asymmetric information. The owners of used cars know what

their vehicles are worth but have no way of credibly demonstrating those values to potential

buyers. Thus, potential buyers must always worry that the used car they are being offered may be

a low-quality “lemon.” LO6

a. Suppose that there are equal numbers of good and bad used cars in the market and that

good used cars are worth $13,000 while bad used cars are worth $5,000. What is the

average value of a used car?

b. By how much does the average value exceed the value of a bad used car? By how

much does the value of a good used car exceed the average value?

c. Would a potential seller of a good used car be willing to accept the average value as

payment for her vehicle?

d. If a buyer negotiates with a seller to purchase the seller’s used car for a price equal to

the average, is the car more likely to be good or bad?

e. Will the used-car market come to feature mostly, if not exclusively, lemons? How

much will used cars end up costing if all the good cars are withdrawn?

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Feedback: Consider the following example for the different parts below.

Part a:

Suppose that there are equal numbers of good and bad used cars in the market and that

good used cars are worth $13,000 while bad used cars are worth $5,000. What is the

Part b:

By how much does the average value exceed the value of a bad used car? By how much

does the value of a good used car exceed the average value?

Part d:

If a buyer negotiates with a seller to purchase the seller’s used car for a price equal to the

Part e:

Will the used car market come to feature mostly—if not exclusively—lemons? How