PROBLEMS AND APPLICATIONS
I. Each of the following situations involves moral hazard. In each case, identify the principal and the agent, and explain why there is asymmetric information. How does the action described reduce the problem of moral hazard?
a. Landlords require tenants to pay security deposits.
b. Firms compensate top executives with options to buy company stock at a given price in the future:
c. Car insurance companies offer discounts to customers who install anti theft devices in their cars.
2. Suppose that the Live-Long-and-Prosper Health Insurance Company charges $5,000 annually for a family insurance policy. The company’s president suggests that the company raise the annual price to $6,000 to increase its profits. ‘If the firm followed this suggestion, what economic problem might arise? Would the firm’s pool of customers tend to become more or less healthy on average? Would the company’s profits necessarily increase?
3: A case study in this chapter describes how a boyfriend can signal to a girlfriend that he loves her by giving an appropriate gift. Do you think saying “I’Iove you” can also serve as a signal? Why or why not?
4. Some AIDS activists believe that health insurance companies should not be allowed to ask applicants if they are infected with the HIV virus that causes AIDS. Would this rule help or hurt those who are HIV-positive? Would it help or hurt those who are not positive? Would it exacerbate or mitigate the problem of adverse selection in the market for health insurance? Do you think it would increase or decrease the number of people without health insurance? In your opinion, would this be a good policy?
5. The government is considering two ways to help the needy: giving them cash or giving them free meals at soup kitchens. Give an argument for giving cash. Give an argument, based on asymmetric information, for why the soup kitchen may be better than the cash handout.
6. Ken walks into an ice-cream parlor.
WAITER:”We have vanilla and chocolate today.
KEN I’ll take vanilla.
WAITER I almost forgot. We also have strawberry.
KEN In that case, I’ll take chocolate.
What standard property of decision making is Ken violating? (Hint: Reread the section on Arrow’s impossibility theorem.)
7. Three friends want to attend a music concert and are trying to decide for which concert they should buy tickets. Here are their preferences..
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