Exam Terms 1

Question 1

Moral Hazard

Answer 1

Moral hazard is a situation characterized by inefficient distribution of
resources when agents involved have asymmetric information, which results from principal
not being able to observe the agent’s actions. Under moral hazard both sides of the
principal-agent relationship suffer economic losses: agents because of low wages;
principals because of low profits.

Question 2

Moral Hazard - Example

Answer 2

Moral hazard can occur when governments make the decision to bail out large corporations. Bailouts send a message to executives at large corporations that any economic costs from engaging in excessively risky business activities (in order to increase their profits) will be shouldered by someone other than themselves

Question 3

Adverse Selection

Answer 3

Adverse selection refers to an incomplete contractual situation in which
a principal cannot observe the quality of the product or service offered by an agent who
knows the quality (Akerlof, 1970; Wilson, 1980). According to standard economic theory,
agents will take advantage and behave opportunistically under such an information
asymmetry if they can do so. This will lead to the crowding out of high quality products.
Under adverse selection both sides of the market suffer economic losses.

Question 4

Adverse Selection - Example

Answer 4

Remember the example with the lemons market. Here as a
result of adverse selection the owners of good cars cannot sell them, but
they do not take advantage of the uninformed party. The owners of bad
cars just try to sell their cars, which is predicted by the buyers. So, no one
is really taking advantage of anyone.

Question 5

Screening

Answer 5

Screening is an action taken by an uninformed person to determine the in-
formation possessed by informed people.

Examples are buyers test-driving
several used cars or letting them be checked by an expert. On the labor
market, assessment centers or job interviews are examples of potential em-
ployers screen applicants.

Question 6

Signaling

Answer 6

Signaling is an action taken by an informed person to send information to
an uninformed person.

Examples are the distribution of favorable reports
on a firm’s products by an independent testing agency or guarantees on
a firm’s products. On the labor market, education (level, quality of the
institution etc.) is a signal of an individual’s capabilities.

Question 7

Risk Adversion + Condition on utility function

Answer 7

Someone is risk adverse if he/she is unwilling to make a faIr bet

Between certain outcome and the lottery with the same expected value risk
averse person chooses sure outcome:

u(pA + (1 − p)B) > pu(A) + (1 − p)u(B)

Question 8

Commitment Device + Example

Answer 8

A commitment device is a way of changing incentives so as to make otherwise empty threats or promises credible

Doomsday device in the Dr. Strangelove movie is a perfect commitment device.
It creates credible threat because its creators cannot stop it if they are attacked.
Since the creators of Doomsday device removed the possibility of them stopping
it, the threat is credible and other party is not willing to attack.

Question 9

Gambler’s Fallacy + example

Answer 9

The gambler’s fallacy is the mistaken belief that if an event occurred more frequently than expected in the past then it’s less likely to occur in the future (and vice versa), in a situation where these occurrences are independent of one another

Example:
people expect that the probability of
tails becomes higher in a sequence of coin
tosses if there was a long string of heads

Question 10

Hot-Hand fallacy + example

Answer 10

The hot hand fallacy is the irrational belief that if you win or lose several chance games in a row, you are either “hot” or “cold,” respectively, meaning that the streak is likely to continue and has to do with something other than pure probability.

Example:

people expect that if the slot
machine “paid out” it will continue doing
so in the future

Question 11

Overconfidence + example

Answer 11

Overconfidence bias is the tendency for a person to overestimate their abilities. It may lead a person to think they’re better-than-average in something compared to others.

Example:
"Do you think you are among 
top 50% of people ranked by 
your driving skills or among 
bottom 50%"

Always more than half answer
they are among top 50%