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EC 260 > Lesson 3.3 > Flashcards

Lesson 3.3 Flashcards

1
Q

how has internet commerce affected monopolies?

A

Monopolies tend to break down as consumers can search and compare across many sellers

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2
Q

what does a lemons market arise from?

A

info differences between buyers and sellers/asymmetric info

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3
Q

is lemons market a market failure?

A

yes

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4
Q

what does lemon mean?

A

Lemon is used to refer to a used car that turns out to have a lot of problems not apparent at the time of purchase

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5
Q

what does a gem mean?

A

Used cars with no hidden defects

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6
Q

how many lemons are in used car market and why in 2 words

A

A disproportionate number of lemons turn up in the used car market due to info asymmetry

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7
Q

explain why are there a lot of lemons in used care market?

A

Since only sellers know true value of care they are selling, buyers will not pay more than average, this drives sellers of quality used cars/gems out of the market and drives sellers of lemons into the market because they will be happy to receive an average price

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8
Q

what happens in insurance with perfect info?

A

If insurer could distinguish between high risk and low risk groups, managers could charge competitive premiums and each group would buy insurance

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9
Q

what is competitive premium for each group?

A

expected losses

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10
Q

perfect info insurance - utility with insurance

A

initial wealth - premium

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11
Q

perfect info insurance - utility no insurance

A

probability(wealth if loss) + probability (wealth if no loss)

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12
Q

perfect info insurance - who will buy insurance

A

High risk drivers and low risk drivers will choose to buy insurance since they have higher utility with insurance

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13
Q

asymmetric info insurance - what do we assume about managers

A

Assume insurers are unable to distinguish between high and low risk drivers

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14
Q

asymmetric info insurance - what happens if there is equal number of low and high risk drivers

A

insurer can break even by charging the average premium

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15
Q

asymmetric info insurance - who will buy insurance

A

high risk drivers will buy insurance but low risk drivers will not because expected utility is higher without insurance

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16
Q

asymmetric info insurance - what kind of market is this

A

perfect lemons market

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17
Q

asymmetric info insurance - explain adverse selection

A

There is an adverse selection of drivers who choose to purchase insurance

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18
Q

asymmetric info insurance - who suffers

A

The people who suffer are the low risk drivers who are priced out of the market and insurance company because they are only insuring high risk drivers

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19
Q

2 ways managers can restore asymmetric info for insurance

A

1) increasing info about individual drivers

2) using strategic design in offering insurance choices to drivers

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20
Q

what does increasing info about individual drivers strategy rely on?

A

Relies on insurance market being highly competitive

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21
Q

explain increasing info about individual drivers strategy

A

possessing information about the expected loss from individual drivers is valuable since it will allow insurers to tailor a premium that will appeal to low risk drivers while continuing to charge high risk drivers a higher premium that reflects the differences in their expected losses. Insurers will compete with rival firms to get better information since this will mean higher profits if they can insure more drivers by attracting the low risk drivers who would otherwise opt out of buying insurance if they faced the same premium as the high risk drivers.

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22
Q

what does using strategic design in offering insurance choices to drivers strategy induce?

A

Induces policyholder to reveal info about themselves

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23
Q

explain defined contribution plan

A

employer or employee makes explicit contributions to pension plans. There is no guarantee of money in retirement

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24
Q

explain annuity

A

converts principal into constant stream of income for the rest of life

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25
Q

annuity market w perfect info - what does perfect info mean

A

health status of each individual is known both to that person and to annuity firm

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26
Q

annuity market w perfect info - explain what happens here

A

Each person receives annuity based on own health status and no one subsidizes anyone else

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27
Q

annuity market w perfect info - how do we calculate annuity

A

Divide principal by life expectancy to get annuity payments

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28
Q

annuity market w asymmetric info - what does asymmetric info mean

A

person knows health status but annuity firm does not

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29
Q

annuity market w asymmetric info - what happens if person lives long time

A

annuity firm loses money

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30
Q

annuity market w asymmetric info - what happens if person lives short period

A

annuity firm gains money

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31
Q

annuity market w asymmetric info - what happens if person lives for what is expected

A

annuity firm breaks even

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32
Q

annuity market w asymmetric info - what will firm do

A

Firm will want to break even - they find average life expectancy and base annuity base off of that and a set amount of principal. If every person bought this annuity, the firm would break-even

33
Q

annuity market w asymmetric info - will poor health people buy annuity

A

Those in poor health will be unlikely to buy the annuity because they could just withdraw more money directly

34
Q

annuity market w asymmetric info - will avg health people buy annuity

A

Those in average health will be indifferent, it might reduce some uncertainty

35
Q

annuity market w asymmetric info - who will buy annuity

A

Only those in average or better health will buy the annuity

36
Q

annuity market w asymmetric info - if only avg or better health people buy, what happens?

A

In this scenario - the firm will lose money as only those in average or better health will buy annuity. Adverse selection will cause this market to break down

37
Q

evidence of adverse selection in annuity market

A

If average life expectancy of annuitants is greater than for the population, managers will find that annuitants live longer on average so there is adverse selection as we would expect those in good health to buy annuities

38
Q

what would we expect if there was adverse selection in life insurance market

A

If there was adverse selection, we would expect healthier people would be less inclined to buy insurance and mortality rates for insured population would be higher than average

39
Q

what actually happens in life insurance market

A

mortality rates are lower among those who have life insurance. This establishes that managers have been effective in establishing health status of policy holders and offering insurance to those in good health. There is no adverse selection here.

40
Q

explain adverse selection in insurance

A

those who are in bad health are more likely to buy life insurance

41
Q

how can a manager not obtain credible info

A

A manager cannot obtain credible info just buy asking, you will lie

42
Q

what does insurer know?

A

1) some drivers are high risk and some are low risk

2) drivers know whether they are good or bad drivers

43
Q

how should managers design policies

A

Managers should design policies so good drivers choose one policy and bad drivers choose another

44
Q

policy A - full insurance

A

high premium designed to be bought by high risk drivers and offers full insurance

45
Q

define full insurance

A

every loss is paid in full

46
Q

policy B - deductible

A

low premium but big deductible (for good drivers)

47
Q

define deductible

A

when insurer does not pay the full loss but pays loss minus some fixed amount

48
Q

policy C - flat premium

A

High premium that is constant from year to year (designed to appeal to high-risk drivers)

49
Q

policy D - experience related premium

A

high premium, higher than 3, if there are no claims, premium falls to level below 3. If there are claims, premium stays at high level higher than 3 (good drivers)

50
Q

what policy do policyholders choose?

A

one that maximizes expected utility

51
Q

define self selection menu

A

when buyers act in their own self-interest and use their private info about their loss probabilities to select policies

52
Q

which policy would survive if there was adverse selection

A

only policy 1 would survive

53
Q

define separating equilibrium

A

this solution to adverse selection induces policyholders to select their respective risk types

54
Q

info asymmetry in job market

A

There is info asymmetry before candidate and interviewer

55
Q

job market - what do managers know

A

Managers know that on average people with good job skills have an easier time overcoming academic hurdles

56
Q

job market - direct cost of education

A

Direct costs of education mount as courses are repeated for those with low quality job skills

57
Q

job market - how does adverse selection arises

A

If employers offered low entry wages to all new employees, only the lower quality applicants will be in the hiring pool

58
Q

job market - how to prevent adverse selection

A

Managers may give people who have completed at least x courses a higher salary

59
Q

job market - what do universities do

A

If a university wishes to signal to the market that its graduates are of high quality it must set standards sufficiently high to discourage low skilled people

60
Q

define experienced goods

A

products whose quality cannot be determined until they are consumed

61
Q

3 examples of experienced goods

A

car, appliances, electronics

62
Q

product market - what is there incentive for low quality producers to do?

A

There is incentive for low quality producers to advertise products as high quality

63
Q

product market - what will consumers not pay

A

Consumers will not pay high quality price if they do not know quality until after

64
Q

product market - what do managers do

A

Managers take actions to create separating equilibrium so consumers can accurately determine product quality. They do this by offering product warranties.

65
Q

product market - how do high quality producers beat low quality producers

A

High quality producer can afford to out-warranty the low-quality producer

66
Q

product market - explain how this is similar to auctions

A

the person who values the item the most just needs to outbid the person who values the item the second most

67
Q

how does adverse selection arise in product market

A

sellers know quality of good but consumers don’t

68
Q

explain adverse selection

A

lack of equal info among parties before transaction takes place

69
Q

explain moral hazard

A

problem of hidden action resulting from adverse selection

70
Q

what do adverse selection and moral hazard both do?

A

Both adverse selection and moral hazard can lead to market failures

71
Q

what price will buyers pay in lemons market?

A

since buyers know there will only be lemons, they will not pay avg value price but the price of the lemons

72
Q

how to calculate optimal premium for auto insurance

A

1) expected claims/groups = premium if all types buy policy
2) see who would buy insurance and change premium as you go down
3) when you get left with who buys,
4) certainty equivalent = no insurance expected utility = Wealth function and find wealth
5) value of car - certainty equivalent = premium group would be willing to pay

73
Q

in an actively competitive market, where is adverse selection reduced to?

A

to the cost of info

74
Q

what are premiums in perfect info?

A

expected loss

75
Q

how to determine length of warranty such that profit per house is larger than if they offered no warranty?

A

profit with no warranty = profit with warranty

76
Q

warranty cost of high quality good vs low quality good

A

warranty cost is larger for low quality good

77
Q

consumer reservation price for high quality good vs low quality good

A

higher for high quality good

78
Q

moral hazard - would entrpreneur using debt financing prefer risky or safe project?

A

risky - they can leave debt unpaid if things go bad

EC 260 (11 decks)

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