PROBLEMS AND APPLICATIONS

1. In each of the following cases, identify whether the problem is adverse selection or moral hazard, and explain your answer. How might the problem be dealt with?

   1. Rick has gotten a large advance to write a textbook. With the money in hand, he prefers spending his time sailing rather than sitting in his office working on the book.

   2. David is trying to get a large advance to write a textbook. He knows, but publishers don’t, that he did poorly on the writing portion of his entrance exam for graduate school.

   3. Brenda is buying a life insurance policy. She knows that members of her family tend to die young.

   4. Maria, who has a large life insurance policy, spends her vacation pursuing her favourite hobbies: skydiving, bungee jumping, and bull-fighting.

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2. Nation A has a well-developed financial system, where resources flow to the capital investments with the highest marginal product. Nation B has a less developed financial system from which some would-be investors are excluded.

   1. Which nation would you expect to have a higher level of total factor productivity? Explain. (Hint: See the appendix to Chapter 8 for the definition of total factor productivity.)

   2. Suppose that the two nations have the same saving rate, depreciation rate, and rate of technological progress. According to the Solow growth model, how does output per worker, capital per worker, and the capital–output ratio compare in the two countries?

   3. Assume the production function is Cobb–Douglas. Compare the real wage and the real rental price of capital in the two countries.

   4. Who benefits from having a better-developed financial system?

3. Some commentators argue that when a financial firm is rescued by the government in the midst of a financial crisis, the firm’s equity holders should be wiped out, but the firm’s creditors should be protected. Does this solve the moral hazard problem? Why or why not?

4. In recent years, as described in this chapter, both the United States and Greece have experienced increases in government debt and a significant economic downturn. In what ways were the two situations similar? In what ways were they different? Why did the two nations have different policy options at their disposal?