Question 1

Adverse selection and moral hazard are problems that arise in the presence of asymmetric information.

Accepted Answer

Adverse selection and moral hazard both occur when one party in a transaction has more information than the other, creating a situation of asymmetric information. Adverse selection refers to the scenario in which an insurer or lender faces a high risk of providing coverage or funding to individuals who are most likely to file claims or default on their loans. Moral hazard, on the other hand, refers to the scenario in which individuals behave differently once they are insured or receive funding, taking on more risk than they would if they were not insured or funded. Both issues can lead to market inefficiencies and negative outcomes.

Question 2

In the area of market signaling, education is a strong signal in the job market because
A) it tells employers that you have gained skills that will be useful in the work place.
B) education is costly to obtain.
C) education is less costly to obtain for highly productive individuals who are also likely to be highly productive in the work place.
D) firms can easily verify your level of education.

Accepted Answer

The answer of In the area of market signaling, education...

Question 3

Jim used to be very careful with his car. However, once he bought full auto insurance on it, he stopped turning on his alarm or even locking it when parking it. This is an example of adverse selection.

Accepted Answer

This is an example of moral hazard, not adverse selection. Moral hazard occurs when someone takes more risks because they are insulated from the consequences, such as being less careful with a car because it's fully insured. Adverse selection involves a party using information that the other party is unaware of, to make a decision.

Question 4

Moral hazard occurs when one party to a contract changes his behavior in response to that contract and thus passes on costs of that behavior to the other party.

Accepted Answer

This is the definition of moral hazard. When one party knows that the other party is responsible for covering any losses or damages, they may take risks or act irresponsibly, passing the cost onto the other party.

Question 5

A lender faces a(n) ________ problem when the lender lends funds to a borrower for a specific purpose and the borrower then opportunistically uses the funds for another purpose.
A) adverse selection
B) moral hazard
C) external cost
D) free‐rider

Accepted Answer

This is an example of moral hazard, where the borrower takes on additional risk knowing that the lender will bear the cost of any negative outcomes. Adverse selection refers to the problem of asymmetric information before the loan is made. External cost and free-rider are not relevant concepts in this scenario.

Question 6

Life insurance companies require that prospective policy holders have a medical check‐up before the companies will sell the policy because of a(n) ________ problem in which the insured could be ________ than expected.
A) moral hazard; healthy and live longer
B) moral hazard; unhealthy and die sooner
C) adverse selection; healthy and live longer
D) adverse selection; unhealthy and die sooner

Accepted Answer

Adverse selection refers to a situation where the seller has less information than the buyer, leading to the potential for those who are more likely to claim insurance (in this case, unhealthy individuals) to be more inclined to buy it. Life insurance companies require medical check-ups to mitigate this risk by better assessing the health status of the insured, aiming to prevent a scenario where they are more likely to insure individuals who are at a higher risk of dying sooner than expected.

Question 7

Relating to the Economics in Practice on page 361: Which of the following is an example of an advertisement in which the fact that something is NOT mentioned indicates that the product is unlikely to be desirable?
A) an advertisement for hot dogs that mentions that it meets certain religious dietary requirements but fails to explain those requirements in a way that would be understood by most people
B) an advertisement for a sneaker that mentions the endorsement of one sports star but fails to mention the sports stars that have endorsed competing products
C) an advertisement for a 30-year old lawn tractor that mentions the color of its paint and the number of cup holders it has but makes no mention of the condition of its engine
D) an advertisement for ice cream that describes the variety of flavors available and the way it tastes but makes no mention of the ice cream's nutritional content

Accepted Answer

In this advertisement, the fact that the condition of the engine is not mentioned suggests that it is not in good condition and therefore not desirable. The advertisement focuses on trivial features such as the color and number of cup holders, rather than the functionality of the tractor.

Question 8

You cause an automobile liability insurance company to face a moral hazard problem when you take ________ driving precautions ________ you buy automobile liability insurance from the company.
A) fewer; after
B) more; after
C) fewer; before
D) the same; before and after

Accepted Answer

Taking fewer driving precautions after buying automobile liability insurance creates a moral hazard problem for the insurance company. This is because the policyholder may be less incentivized to drive safely and avoid accidents since they know the insurance company will cover the cost of damages. On the other hand, taking more driving precautions after buying insurance would reduce the moral hazard problem by decreasing the likelihood of an accident and subsequent insurance claim. Taking precautions before buying insurance or maintaining the same level of precautions before and after buying insurance does not directly affect the moral hazard problem.

Question 9

You own a car dealership and pay all of your sales people a flat salary. As a result, they don't work very hard to generate sales. This is an example of ________.
A) adverse selection
B) moral hazard
C) logrolling
D) an externality

Accepted Answer

This situation is an example of moral hazard, where the salespeople have less incentive to work hard because they receive a flat salary regardless of their sales performance. They are not directly affected by the outcome of their efforts, leading to a decrease in productivity. Adverse selection refers to the problem of asymmetric information before the contract is made, logrolling is a political term, and externality is a concept that deals with the impact of economic activities on third parties.

Question 10

Related to the Economics in Practice on page 360: Insurance companies are interested in being legally allowed to obtain the results of genetic testing before deciding on issuing insurance policies to potential buyers, which would lessen the problem of ________ in the health insurance market.
A) moral hazard
B) market signaling
C) adverse selection
D) risk-loving

Accepted Answer

Adverse selection occurs when individuals who are at higher risk of needing insurance are more likely to purchase insurance policies. In the context of health insurance, this means that individuals with genetic predispositions to certain illnesses may be more likely to purchase insurance, which could lead to higher costs for the insurance companies. By obtaining the results of genetic testing, insurance companies could more accurately assess the risk of potential policyholders and adjust their premiums accordingly, which would help reduce adverse selection.

Question 11

Market signals are
A) actions taken by buyers and sellers to communicate quality in the presence of perfect information.
B) only strong if obtaining the signal is more costly for individuals with valued traits than for those with non-valued traits.
C) used to differentiate those who will drive equally carefully whether or not they have auto insurance from those who drive less carefully when they have insurance.
D) used to distinguish between high and low quality and help correct the adverse selection problem.

Accepted Answer

Market signals are used to distinguish between high and low quality and help correct the adverse selection problem. Market signals help to convey information about the quality of a product or service to potential buyers. This enables buyers to differentiate between high and low-quality products, ultimately reducing the problem of adverse selection.

Question 12

The insurance industry is susceptible to adverse selection problems, but not problems of moral hazard.

Accepted Answer

The insurance industry is susceptible to both adverse selection problems and problems of moral hazard. Adverse selection occurs when individuals with higher risk of loss are more likely to purchase insurance, while those with lower risk of loss are less likely to do so. Moral hazard occurs when individuals alter their behavior and engage in riskier activities knowing that they are insured, leading to increased losses for the insurer.

Question 13

Warranties, education, extracurricular activities are all examples of
A) market signals.
B) risk premiums.
C) tools that can correct the moral hazard problem.
D) incentives.

Accepted Answer

The answer of Warranties, education, extracurricular activities are all examples...

Question 14

A lender faces a(n) ________ problem if borrowers with a greater chance of defaulting on their loans get loans from the lender.
A) adverse selection
B) moral hazard
C) external cost
D) free‐rider

Accepted Answer

Adverse selection occurs when borrowers who are most likely to default are the ones who apply for loans. This can result in the lender extending loans to high-risk borrowers and ultimately suffering losses.

Question 15

In the market for used motorcycles there are high-quality motorcycles and low-quality motorcycles. Potential buyers cannot determine prior to purchase whether the motorcycle is high quality or low quality. Which of the following statements best describes what is likely to happen in this market?
A) The price of a used motorcycle will be very close to the value of a high-quality motorcycle, which will encourage people to sell high-quality motorcycles.
B) The price of a used motorcycle will be between the value of a high-quality and low-quality motorcycle. This will encourage people to withdraw high-quality motorcycles from the market.
C) This is an example of adverse selection, as the buyer will have more information about the quality of the used motorcycle than the seller will.
D) Over time the price of a used motorcycle will increase in this market, as there is more of an incentive for owners of high-quality motorcycles to sell than owners of low-quality motorcycles.

Accepted Answer

This scenario is an example of the "lemons problem" described by George Akerlof, where the inability of buyers to distinguish between high-quality and low-quality goods leads to an average price that reflects neither. High-quality goods are undervalued and thus less likely to be offered for sale, while low-quality goods are overvalued, encouraging their sale. This results in a market where the quality of goods decreases over time, as high-quality items are withdrawn.

Question 16

Refer to the Economics in Practice on page 361. Advertisements provide information in two ways-what they say and what they omit.

Accepted Answer

Advertisements can provide information through both the content of the message and by what they choose not to mention or "omit". This can include leaving out certain product details or potential drawbacks in order to present the product or service in a more positive light.

Question 17

Adverse selection is a situation in which asymmetric information results in low-quality goods or low-quality consumers being squeezed out of transactions because they are unable to demonstrate their quality.

Accepted Answer

Adverse selection is a situation where asymmetric information results in high-quality goods or high-quality consumers being squeezed out of transactions because they cannot distinguish themselves from low-quality goods or consumers.

Question 18

Annie, a high school student, baby sits to earn extra cash. In order to differentiate herself from other baby sitters, Annie took a babysitting course from the Red Cross. This is an example of a market signal.

Accepted Answer

Annie's decision to take a babysitting course from the Red Cross signals to potential clients that she is more qualified than other babysitters who have not taken such a course. This differentiation can give her a competitive advantage in the market for babysitting services.

Question 19

Relating to the Economics in Practice on page 363: The smart phone app which allows skiers at a slope to report weather conditions to others would lessen the problem of
A) moral hazard.
B) market signaling.
C) asymmetric information.
D) risk-loving.

Accepted Answer

The smart phone app which allows skiers to report weather conditions helps to reduce asymmetric information. Previously, skiers would only have access to the weather conditions as reported by the ski resort, which may not be entirely accurate. With this app, skiers can report the conditions they are experiencing in real-time, which helps others make better-informed decisions. This reduces the information asymmetry that can exist between the ski resort and skiers, which is a common problem in markets.

Question 20

Relating to the Economics in Practice on page 360: An individual with a parent who has Huntington's disease has a 50 percent chance of also having the disease, and can use this information when deciding on the purchase of health insurance. This is an example of ________ favoring potential insurance buyers.
A) moral hazard
B) asymmetric information
C) market signaling
D) adverse selection

Accepted Answer

Asymmetric information occurs when one party in a transaction has more or better information than the other. In this case, the individual knows their genetic risk, which the insurance company may not, leading to an imbalance in information.

Quiz 17: Uncertainty and Asymmetric Information

Adverse selection and moral hazard are problems that arise in the presence of asymmetric information.

In the area of market signaling, education is a strong signal in the job market because

Jim used to be very careful with his car. However, once he bought full auto insurance on it, he stopped turning on his alarm or even locking it when parking it. This is an example of adverse selection.

Moral hazard occurs when one party to a contract changes his behavior in response to that contract and thus passes on costs of that behavior to the other party.

A lender faces a(n) ________ problem when the lender lends funds to a borrower for a specific purpose and the borrower then opportunistically uses the funds for another purpose.

Life insurance companies require that prospective policy holders have a medical check‐up before the companies will sell the policy because of a(n) problem in which the insured could be than expected.

Relating to the Economics in Practice on page 361: Which of the following is an example of an advertisement in which the fact that something is NOT mentioned indicates that the product is unlikely to be desirable?

You cause an automobile liability insurance company to face a moral hazard problem when you take driving precautions you buy automobile liability insurance from the company.

You own a car dealership and pay all of your sales people a flat salary. As a result, they don't work very hard to generate sales. This is an example of ________.

Related to the Economics in Practice on page 360: Insurance companies are interested in being legally allowed to obtain the results of genetic testing before deciding on issuing insurance policies to potential buyers, which would lessen the problem of ________ in the health insurance market.

Market signals are

The insurance industry is susceptible to adverse selection problems, but not problems of moral hazard.

Warranties, education, extracurricular activities are all examples of

A lender faces a(n) ________ problem if borrowers with a greater chance of defaulting on their loans get loans from the lender.

In the market for used motorcycles there are high-quality motorcycles and low-quality motorcycles. Potential buyers cannot determine prior to purchase whether the motorcycle is high quality or low quality. Which of the following statements best describes what is likely to happen in this market?

Refer to the Economics in Practice on page 361. Advertisements provide information in two ways-what they say and what they omit.

Adverse selection is a situation in which asymmetric information results in low-quality goods or low-quality consumers being squeezed out of transactions because they are unable to demonstrate their quality.

Annie, a high school student, baby sits to earn extra cash. In order to differentiate herself from other baby sitters, Annie took a babysitting course from the Red Cross. This is an example of a market signal.

Relating to the Economics in Practice on page 363: The smart phone app which allows skiers at a slope to report weather conditions to others would lessen the problem of