Printed Page EM-23(cont.)

Free-Response Review Questions

  1. Question

    Identify whether each of the following situations reflects moral hazard or adverse selection. Propose a potential solution to reduce the inefficiency that each situation creates.



    1. When you buy a second-hand car, you do not know whether it is a lemon (low quality) or a plum (high quality), but the seller knows.



    2. People with dental insurance might not brush their teeth as often, knowing that if they get cavities, the insurance will pay for the fillings.



    3. A company does not know whether individual workers on an assembly line are working hard or slacking off.



    4. When making a decision about hiring you, prospective employers do not know whether or not you are a productive worker.
    Identify whether each of the following situations reflects moral hazard or adverse selection. Propose a potential solution to reduce the inefficiency that each situation creates.

    Rubric for FRQ 1 (8 points)

    1 point: Adverse selection

    1 point: Sellers could offer a warranty with the car that pays for repair costs.

    1 point: Moral hazard

    1 point: Each insured person can be made to pay a co-payment of a certain dollar amount each time he or she gets a filling.

    1 point: Moral hazard

    1 point: Pay the workers “piece rates,” that is, pay them according to how much they have produced each day.

    1 point: Adverse selection

    1 point: Provide potential employers with references from previous employers.

  2. Question

    Suppose individuals or corporations (for example home-buyers or banks) believe that the government will “bail them out” in the event that their decisions lead to a financial collapse. This is an example of what problem created by asymmetric information? How does this situation lead to inefficiency? What is a possible remedy for the problem?(3 points)

Discussion Starters

  1. Question

    In what situations have you experienced asymmetric information? What screening or signaling was involved?

    Students might discuss experiences with job seeking or the purchase of used goods or insurance. In a hiring situation, perhaps they took a screening test. When purchasing car insurance, they would have revealed information about their driving record. These are among many possible examples.

  2. Question

    Do you experience moral hazard by taking fewer precautions when the cost of damage would be at least partially someone else’s problem? For example, this might be the case when a product is under warranty, a car or home is being rented, or insurance would cover the cost of damage.

    Students might take fewer precautions when their parents would pay for the damage, when they are insured, or when the personal property at risk belongs to someone else.

  3. Question

    Describe a case in which you used a seller’s reputation to deal with asymmetric information.

    Answers might involve the purchase of concert tickets or other items online.
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