✏ Information Economics Practice

Learning examples

✏ Laundry detergent is a frequent purchase for most households. That high-quality detergents are advertised more heavily can be seen as an example of

1. adverse selection.
2. moral hazard.
3. market signaling.
4. the principal-agent problem.
5. None of the above is correct.

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Answer: C High-quality detergents can expect more repeat sales and thus advertising is relatively more profitable for them.  ✅

✏ The signaling model of education would necessarily break down if

1. skills learned in school were useful in employment.

2. the costs of acquiring education were equal for individuals of different abilities.

3. individuals could not identify their own abilities.

4. (B) and (C)

5. (A), (B), and (C)

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Answer: D In order for signaling to work, the opposite of (B) and (C) must hold. If (A) is true, education can still serve as a signal, but it is less costly than otherwise.  ✅

Practice Examples

✏ A manufacturer is less likely to offer warranties for its products if

1. consumer misuse is a likely source of failure and difficult to detect.
2. its products are of higher-quality than those of its competitors.
3. its products are of lower quality than those of its competitors.
4. (A) and (B)
5. (A) and (C)

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Answer: E Choice (B) is the only factor that makes warranties a strong signal. If consumers can affect the probability of breakdowns, the manufacturer has a moral hazard problem with offering a warranty.  ✅

✏ When renting a car, the rental firm will sell you a waiver that releases you from any monetary liability for damage to the car from collisions. Compared to other types of car insurance, these waivers seem quite expensive. A possible explanation is

1. the moral hazard problem is more severe.
2. the adverse selection problem is more severe.
3. it is more expensive to repair rental cars.
4. (A) and (B)
5. (B) and (C)

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Answer: D A waiver that releases you from monetary liability would both attract bad drivers (adverse selection) and change people’s incentives so they become less cautious (moral hazard). Both of these effects would drive up the cost of the waiver.  ✅

✏ From whom would you prefer to buy a used car (everything else being equal)?

1. Someone trading it in for a new car.
2. An amateur car mechanic.
3. A graduating Ph.D. student returning home to his native country.
4. A family planning to buy another used car.
5. (A) or (D)

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Answer: C The lemons problem happens when the seller knows more than you do and chooses to sell/get rid of a product that is of low quality. The Ph.D. student is the only potential seller who is not selling by choice, and because of this, there is a good chance that the car might be of high quality.  ✅

✏ Which of the following is the best example of adverse selection?

1. A consumer buys a lawnmower that does not perform as advertised.
2. A restaurant owner who has a fire insurance policy sets fire to the restaurant.
3. Risk-averse individuals always buy more insurance than they need.
4. Less healthy people are more likely to purchase health insurance.
5. Only manufacturers of high-quality products choose to offer warranties.

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Answer: D Note that (B) is an example of moral hazard, and (E) is an example of signaling.  ✅

✏ Most states require owners of automobiles to buy liability insurance. For the sellers of insurance policies, this may alleviate

1. the moral hazard problem.
2. the adverse selection problem.
3. the principal-agent problem.
4. All of the above are correct.
5. None of the above is correct.

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Answer: B When the lowest risk car owners do not buy insurance, the insurers face an adverse selection problem. This problem disappears when the lowest risk drivers are prevented by law from opting out of the market. The moral hazard problem is still present with compulsory insurance. The principal-agent problem does not apply here—the car owner is not the agent of the insurance company.  ✅

✏ Long-term stock options to top management in publicly traded corporations:

1. align the interests of managers and stockholders.
2. give managers incentives not to focus on the short term.
3. (A) and (B)

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Answer: C Stock options have all these effects.  ✅

✏ An unlimited return policy for a mail-order clothing company may

1. function as a signal to customers.
2. reduce customer uncertainty about product quality.
3. (A) and (B)

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Answer: C A firm that is willing to offer a liberal return policy anticipates higher consumer satisfaction with its products. This firm is therefore signaling its confidence in its product to consumers, which also serves to reduce customer uncertainty.  ✅

Stretch Question

✏️ There are 100 used cars potentially available for sale in the town of Manchester. The owners of the low- quality used cars value their cars at $4000, while the high-quality car owners value their cars at $8000. Buyers believe that 50 percent of cars are lemons (low quality). There are 100 potential buyers who value low-quality cars at $5000 and high-quality cars at $10,000. The price a buyer is willing to pay is a function of the average car quality they expect to be offered on the market. We can conclude that in the long run:

1. buyers are willing to pay $7500, and only low-quality cars will be offered for sale.
2. buyers are willing to pay $7500, and both types of cars will be offered for sale.
3. buyers are willing to pay $5000, and only low-quality cars will be offered for sale.
4. buyers are willing to pay $10,000, and both types of cars will be offered for sale.
5. buyers are willing to pay $10,000, and only high-quality cars will be offered for sale.

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Short Run - let’s assume that the peaches are sold

$50\% \times 10{,}000 + 50\% \times 5{,}000 = 7{,}500$

Buyers won’t pay more than $7500

Medium Run -

• Sellers of peaches value their peaches at $8000. Therefore, they won’t sell the peaches for $8000.
• Sellers of peaches will leave the market.
• Only Lemons will be sold.
• It will all fall apart.

Long Run

• Only Lemons will be sold. They are worth $4000 to the sellers and $5000 to the buyers, so the price will be between $4000 and $5000.

Answer: C If all used cars are offered for sale, the expected value of a car from the perspective of a buyer is $0.5(5{,}000) + 0.5(10{,}000) = \$7{,}500$. Since the buyers’ initial willingness to pay is less than $8000, only low-quality cars will be offered for sale. But if only low-quality cars are offered, buyers will only be willing to pay $\$5{,}000 < \$8{,}000$. Therefore, we conclude that in the long run, only low-quality cars will be offered for sale.  ✅