Ch. 19 adverse selection

Question 1

Adverse selection refers to a situation where

Answer 1

sellers have more information than buyers have, or vice versa, about some aspect of product quality, although typically the more knowledgeable party is the seller.

Question 2

Adverse selection occurs when _________ information is exploited.

Answer 2

asymmetric

Question 3

adverse selection per book

Answer 3

refers to the fact that “bad types” are likely to be selected in transactions where one party is better informed that the other.

Question 4

examples of adverse selection includes

Answer 4

higher risk individuals being more likely to purchase insurance, more low-quality cars (lemons) being offered for sale, or lazy workers being more likely to accept job offers.

Question 5

Adverse selection is a _________ problem that arises from hidden information about risks, quality, or character.

Answer 5

precontractual

Question 6

adverse selection problem is more easily illustrated in the market for ________.

Answer 6

insurance

Question 7

insurance is a wealth creating transaction that moves _________ from those who don’t want it to those who are willing to bear it for free.

Answer 7

risk

Question 8

risk-neutral individual values a lottery at ______ expected value.

Answer 8

its (as is)

Question 9

A risk-averse consumer values a lottery at _____ than its expected value.

Answer 9

less

Question 10

For instance, a risk-averse consumer might be willing to sell the $100 coin toss lottery for $40, whereas a risk-neutral consumer would be willing to pay $50 for the same lottery. If the two of them transact, say at a price of $45, they create wealth by moving an asset—the lottery—to a higher-value use. After the transaction, the risk-averse seller has $45, a sure payout that he values more than the lottery, and the risk-neutral buyer pays only $45 for a lottery that she values at $50.

Answer 10

risk neutral buyer values at 50.

risk averse seller values at 40.

transaction = 45$.

therefore, risk-neutral buyer pays only $45 for a lottery that she values at $50.

Question 11

A lottery is a ________ with a payment attached to each outcome.

Answer 11

random variable

Question 12

For example, suppose that Rachel owns a $100 bicycle that might be stolen. The possibility of theft means that the payoff from owning the bicycle is like that of a lottery: lose $100 if the bike is stolen and lose nothing if it isn’t. If the probability of theft is 20%, the expected cost of the lottery is ___________.

Answer 12

($100)(20%) = 20$

If Rachel purchases insurance for $25 that reimburses her for the value of her stolen bicycle, she eliminates the risk.

Question 13

If Rachel purchases insurance for $25 that reimburses her for the value of her stolen bicycle, she eliminates the risk. By voluntarily transacting, both Rachel and her insurance company are made better off. Rachel pays to eliminate the risk, and the insurance company earns $5, on average, for accepting it.

Note that the insurance company never earns $5. If the bike is stolen, it loses $75; if not, it earns $25, so the expected value of offering insurance is ___________.

Answer 13

(20%)( - 75$) + 80% (25$)

= 5$

Question 14

another way to reduce or remove risk is to ______

Answer 14

sell forward contracts

Question 15

If you are risk averse:

a. You value a lottery at more than its expected value.	
b. You like to take gambles.	
c. A lottery is worth less to you than its expected value.	
d. You advertise your attitude toward risk.

Answer 15

c. A lottery is worth less to you than its expected value.

Question 16

Those who choose to insure against theft:

a. Reduce the risk they face.	
b. Pay insurance premiums greater than your expected loss.	
c. Are better off than if insurance was not available.	
d. All of the above

Answer 16

d. All of the above

Question 17

When farmers sell forward contracts in spring for the harvest they will reap in Autumn:

a. Their planting decisions are riskier due to increased uncertainty.	
b. They accept a price higher than the expected price during harvest.	
c. They are worse off because the price today is less than what they could expect to sell their crops for in the autumn.	
d. They are better off because they have a preference for reducing risk.

Answer 17

d. They are better off because they have a preference for reducing risk.

Question 18

adverse selection disappears. if the information _________ disappears.

Answer 18

asymmetry

Question 19

anticipate adverse selection and ________ yourself against it.

Answer 19

protect

Question 20

when you eliminate the information asymmetry - when the company knows who is high risk and who is low risk, then

Answer 20

there is no adverse selection

Question 21

by requiring everyone to purchase insurance

Answer 21

you reduce low risk purchasers to exit the market

Question 22

In financial markets, adverse selection arises when owners of companies seeking to sell shares to the public __________ than do potential investors.

Answer 22

know more about the prospects of the company

Question 23

winner’s curse of common value is a type of ___________.

Unless the winning bidder anticipates that she will win only when she has the most optimistic estimate of the item’s true value, she’ll end up overbidding. Only if bidders anticipate the winner’s curse—by bidding as if they have the highest estimate—will they bid low enough to avoid overpaying.

Answer 23

adverse selection

Question 24

People are more willing to buy an insurance product when:

a. They are less risk averse.	
b. They face greater risk.	
c. They face less risk.	
d. They are no risk.

Answer 24

b. They face greater risk.

Question 25

If an insurance company cannot distinguish between the riskiness of potential customers, then:

a. Their risk pool will have relatively more high risk customers than the population at large.	
b. They primarily sell to low risk customers.	
c. They earn more because they can overcharge the low risk customers.	
d. They can break at least even if they charge a rate based on the average risk in the population at large.

Answer 25

a. Their risk pool will have relatively more high risk customers than the population at large.

Question 26

The low-risk consumers are ________ because it is difficult to transact with them profitably.

Answer 26

not served

Question 27

Adverse selection represents a ________ profitable, but _________ , wealth-creating transaction

Answer 27

potentially

unconsummated/unfinished

Question 28

screening and signaling are two ways to overcome the obstacles to transacting with ________.

Answer 28

low-risk individuals

Question 29

screening

Answer 29

a solution to the problem of adverse selection that describes the efforts of a less informed party to gather information about the more informed party.

uninformed party’s effort to learn the information that the other party has.

Question 30

A successful screen means that

Answer 30

it is unprofitable for bad types to mimic the behavior of good types. Any successful screen can also be used as a signal.

Question 31

obvious solution to adverse selection is to

Answer 31

gather information so you can distinguish high risk from low risk

Question 32

for example, the insurance company can distinguish between high- and low-risk consumers, then ___________

Answer 32

it can offer two different policies to the two groups—a low-price policy to the low-risk group and a high-price policy to the high-risk group.

Question 33

for example - If you give an insurance company permission to look at your credit report,

Answer 33

you can get car insurance at a low price, provided your credit is good.

Question 34

Some restrictions for checking credit score and credit report reduce the amount of information available to insurance companies and raises the cost of insurance to ______________ .

Answer 34

good drivers

Question 35

By offering consumers a _______ , you can get them to reveal information about themselves (risk) by the ______ they make.

Answer 35

menu of choices

choices

Question 36

By offering _________ , the insurance company can transact (partially) with the low-risk consumers.

Answer 36

partial insurance

Question 37

screening is essentially the efforts of the less informed party, the __________, to gather information about the more informed party, the ________.

Answer 37

insurance company

consumers

Question 38

A successful screen has one critical requirement: it must not be __________ for high-risk consumers to ________ the choice of low-risk consumers.

Answer 38

profitable

mimic

Question 39

if high risk individuals purchase partial insurance, the screen fails and the insurance company, _________.

Answer 39

loses money

Question 40

If you’re a low-risk individual, you may be able to ________ your own expected insurance costs by purchasing a policy with a ___________.

Answer 40

lower

large deductible or copayment

Question 41

Buying a policy with a ________ deductible signals that you expect your insurance costs to be ______.

Answer 41

small

high

Question 42

this allows insurance companies and software companies like discussed in other chapters to

Answer 42

price discriminate

Question 43

the lemons problem

Answer 43

used car market and adverse selection

Question 44

to solve a lemon (bad car) problem

Answer 44

you can ask for a money back guarantee, that way sellers of good cars will accept because the car won’t be returned.

Lemon owners would be unwilling to offer guaranties like this. Warranties on products serve a similar purpose.

Question 45

Manufacturers of high-quality, durable products are ___________ because they don’t expect to have to make many repairs.

Answer 45

more willing to offer longer warranties

Question 46

Zappos - adverse selection.- by offering a 4,000 to quit

Answer 46

the company made it profitable for low quality workers to identify themselves as such

Question 47

Incentive compensation is another way that employers ___________.

Answer 47

identify and avoid low-quality workers

Question 48

The asymmetric information means that workers know which type they are but you don’t.

Answer 48

sellers are the employees

buyers are the employers

therefore, the sellers know more information than the buyer.

employees offering their time and employers accepting and purchasing their time to offer a service.

Question 49

offering commission is another way to

Answer 49

screen out lazy vs hard workers.

Question 50

commission is a perfect screen because

Answer 50

the workers’ own choices (accept or reject) identify their type (lazy or hardworking).

Question 51

most incentive compensation schemes ________ workers to risk.

Answer 51

expose

for ex: factors that affect sales like consumer income, rival prices, or interest rates.

Question 52

best screens would be

Answer 52

contract with a flat salary ($500) and combination with commission ($5) on each sale

good workers get a compensation scheme that exposes them to less risk.

Question 53

When offering insurance to groups with different risk profiles:

a. Insurers tend to cater products to the higher risk group.	
b. Insurers serve the lower risk groups because they make fewer claims.	
c. Lower risk groups get more insurance coverage than higher risk groups.	
d. The higher risk groups are offered only get only partial insurance.

Answer 53

a. Insurers tend to cater products to the higher risk group.

Question 54

Screening:

a. represents efforts made by the more informed party.	
b. is when the more informed party reveals her type by the choices she makes.	
c. is when the less informed party gathers information by the choices the more informed party makes.	
d. represents the more informed party being persuaded to reveal information about their type.

Answer 54

c. is when the less informed party gathers information by the choices the more informed party makes.

Question 55

adverse selection results in unconsummated wealth-creating transactions, such as those between:

Answer 55

insurance companies and low-risk consumers;

car buyers and sellers with good cars; or

employers and hardworking employees.

Question 56

When consumers identify themselves by their choices, then

Answer 56

wealth-creating transactions can be consummated

Question 57

Signaling describes the efforts of the more informed parties (consumers) to

Answer 57

to reveal information about themselves to the less informed party (the insurance company).

Question 58

A successful signal is one that

Answer 58

bad types will not mimic.

Question 59

signaling are efforts made by informed parties, the ____________, to get rid of asymmetric information.

Answer 59

low risk consumers

hardworking employees

sellers with good cares

Question 60

signaling is closely related to screening. And every successful screen can also be __________.

Answer 60

used as a signal.

Question 61

to signal, the informed party could use the mechanisms just described: low-risk consumers could ___________ , good employees could ___________ , and sellers with good cars could ___________.

Answer 61

offer to buy insurance with a big deductible

offer to work on commission

include a warranty with the purchase

Question 62

The crucial element of a successful signal is that it must not be profitable for the ________ to mimic the signaling behavior of the good types.

Answer 62

bad types

Question 63

education is another signaling value

Answer 63

students signal they are hardworking when they drop out of the labor force and spend their money to pursue an education. thus earning a higher salary to recoup their investment.

Question 64

any student that is a low quality worker

Answer 64

will not be promoted or retained.

Question 65

advertising and branding can also serve as signals

Answer 65

By investing significant money into branding and advertising a product, firms signal to consumers that theirs is a high-quality product.

Question 66

Low-quality firms won’t mimic this signal because even consumers who buy will

Answer 66

soon learn of its low quality and avoid the brand in the future.

Question 67

branding and advertising signals are called burning money because

Answer 67

the message of the advertisement is less important than the fact that money was spent on it.

for ex - male peacocks in wild - reflect better genes preferred by females.

Question 68

example of burning money

Answer 68

before FDIc, banks were built in granite.

Question 69

Signaling:

a. represents efforts to share information made by the more informed party.	
b. is when the less informed party signals her type by the choices she makes.	
c. is when the less informed party gathers information by the choices the more informed party makes.	
d. represents the less informed party being persuaded to reveal information about their type.

Answer 69

a. represents efforts to share information made by the more informed party.

Question 70

For signaling to work in insurance:

a. It must be profitable for low risk types to reveal their type.	
b. It must not be profitable for high risk types to mimic low risk signals.	
c. The insurer must be able to distinguish between high and low risk types based on the signal.	
d. All of the above.

Answer 70

d. All of the above.

Question 71

adverse selection and internet sales

Answer 71

amazon has made it a point to have good sellers on their marketplace as bad sellers could potentially reflect on all sellers.

amazon has also worked to give sellers a seal of approval and bans incentivized review to design a proper review system without fake reviews and more helpful information. that is how its become a dominant online retailer worldwide.

Question 72

other online sites like eBay will address adverse selection by

Answer 72

authentication and escrow services, insurance, and online reputation.

Question 73

Yelp and adverse selection with positive reviews result in

Answer 73

8% increase in revenues

Question 74

E-commerce platforms, like Amazon.com, restrict their sites to high quality sellers by:

a. Suing all firms with "too many" product reviews.	
b. Soliciting third-party reviews with compensation.	
c. Prominently displaying reviews that other customers considered less informative.	 d. Banning sellers from offering inducements for favourable reviews.

Answer 74

d. Banning sellers from offering inducements for favourable reviews.