Tutorial 7, 8, 9

Question 1

Asymmetric information

Answer 1

One party to a transaction has relevant information that another party lacks.

Question 2

Adverse selection

Answer 2

Adverse selection refers to a situation in which a principal cannot observe the quality of the product or service offered by an agent who knows the quality. 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 crowding out of high quality products. Under adverse selection both sides of the market suffer economic losses.

Question 3

Moral hazard

Answer 3

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 4

Screening

Answer 4

An action taken by an uninformed person to determine the information possessed by informed people.

Question 5

Signaling

Answer 5

An action taken by an informed person to send information to a less-informed person.

Question 6

Lemons market

Answer 6

In a lemons market there are products and services with different quality, which is observable by the seller and unobservable by the buyer.

Question 7

Standard

Answer 7

A metric or scale for evaluating the quality of a particular product

Question 8

Certification

Answer 8

A report that a particular product meets or exceeds a given standard.

Question 9

Cheap talk

Answer 9

Unsubstantiated claims or statements.

Question 10

Pooling equilibrium

Answer 10

An equilibrium in which dissimilar people are treated alike or behave alike.

Question 11

Separating equilibrium

Answer 11

An equilibrium in which one type of people takes actions that allows them to be differentiated from other types of people.

Question 12

Efficiency in production

Answer 12

The principal’s and agent’s combined value (profits, payoffs) is maximized.

Question 13

Efficiency in risk bearing

Answer 13

Risk sharing is optimal in that the person who least minds facing risk - the risk neutral or less risk averse person - bears more of the risk.

Question 14

Principal-Agent problem

Answer 14

How an uninformed principal contracts with an informed agent determines whether moral hazard occurs and how risks are shared.