Econ 101: Chapter 19

Question 1

Private information

Answer 1

when one party to a transaction knows something the other doesn’t

Question 2

Asymmetric information

Answer 2

when two parties don’t have the same information.

Question 3

In the scenario of buying a used car…

Answer 3

the sellers have private information.

Question 4

When sellers have private information…

Answer 4

low quality goods will sell for higher than what they are worth, and high quality goods will sell for lower than what they are worth.

Question 5

Sellers of high quality goods…

Answer 5

may not choose to sell, because they aren’t offered high enough prices.

Question 6

Adverse selection of sellers

Answer 6

the tendency for the selection of goods to be skewed toward more low-quality goods when buyer’s can’t observe quality.

Question 7

the risk of buying low quality goods…

Answer 7

reduces the price buyers will pay, causing high quality goods to exit the market.

Question 8

Adverse selection death spiral (sellers)

Answer 8

the cycle of high quality goods exiting the market continues until only low quality goods are left.

Question 9

risk neutral

Answer 9

indifferent to risk.

Question 10

Adverse selection of sellers results in a…

Answer 10

market failure - people are unable to buy and sell high quality goods (inefficient outcome).

Question 11

3 solutions to adverse selection of sellers

Answer 11

1. buyers can learn from third party verifiers.
2. sellers can signal their product’s quality.
3. Government can increase information or weed out low-quality goods.

Question 12

For a signal to work…

Answer 12

it must be substantially costlier for sellers of low-quality goods to send the signal than for sellers of high-quality goods to do so.

Question 13

Signals are only reliable when…

Answer 13

sellers of high quality goods are much more likely to find it worthwhile to send the signal (price difference).

Question 14

Adverse selection of sellers: government policies

Answer 14

government policy can reveal information to buyers, make it mandatory to reveal info, and keep low quality sellers out of the market.

Question 15

in the scenario of health insurance…

Answer 15

the buyers have private information about their health.

Question 16

when buyers have private information…

Answer 16

the low cost buyers are not likely to buy the product, and high cost buyers are likely to see it as a good deal.

Question 17

low cost buyers are likely to…

Answer 17

not buy the product, as it is too expensive.

Question 18

adverse selection of buyers

Answer 18

the tendency of the mix of buyers to be skewed toward more high-cost buyers when sellers don’t know buyers’ type.

Question 19

adverse selection death spiral (buyers)

Answer 19

when insurance companies charge more, causing more low cost buyers to leave, until only high cost buyers are left.

Question 20

Adverse selection of buyers results in…

Answer 20

a market failure - low cost buyers want to buy, but they can’t as insurance companies don’t know that they are a low cost buyer.

Question 21

letting people opt back into insurance when they need it…

Answer 21

worsens adverse selection.

Question 22

risk aversion

Answer 22

people who dislike risk and uncertainty.

Question 23

risk averse buyers will…

Answer 23

still buy, even if they have private information that they will be lower cost on average.

Question 24

3 solutions to adverse selection of buyers.

Answer 24

1. sellers can use information that is related to buyer’s likely costs.
2. Sellers can offer different contracts so that buyers separate themselves.
3. Government can increase information or directly reduce adverse selection.

Question 25

Deductible

Answer 25

the amount you pay out of pocket before insurance kicks in.

Question 26

high deductible plans are…

Answer 26

only attractive to low-cost customers.

Question 27

low deductible plans are…

Answer 27

only attractive to high cost customers.

Question 28

haivng a high deductible plan means that…

Answer 28

you are only partially insured, as you have to risk some of your own money.

Question 29

To reduce adverse selection of buyers, governments can…

Answer 29

create incentives for buyers to reveal their private information, subsidize insurance, provide insurance, or require everyone to buy insurance.

Question 30

moral hazard

Answer 30

the actions you take because they are not fully observable and you are partially insulated from their consequences.

Question 31

insurance leads people to…

Answer 31

make riskier choices and take fewer precautions.

Question 32

hidden actions

Answer 32

the precautions you take to prevent a bad outcome.

Question 33

hidden actions aren’t…

Answer 33

easily observable by others, so they are private information.

Question 34

moral hazard explains why health care costs…

Answer 34

are higher when everybody is insured.

Question 35

Moral hazard can cause…

Answer 35

for the market to collapse – the bad thing that is insured happens more often.

Question 36

moral hazard (insurance)…

Answer 36

causes insurance prices to go up, leading less people to want to buy insurance.

Question 37

principal-agent problems

Answer 37

the problems that arise when a principal hires an agent to do something on their behalf, but the principal cannot perfectly observe the agent’s actions.

Question 38

5 solutions to moral hazard problems

Answer 38

1. make hidden actions observable by monitoring
2. provide complements that go with the actions you want.
3. give people “skin in the game” or a stake in the outcome.
4. government rules and social norms can align incentives.
5. pick the right kinds of agents.

Question 39

Pay per performance

Answer 39

linking the income your workers earn to measures of their performance.

Question 40

by giving people skin in the game, you are…

Answer 40

also giving them risk.