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 antitheft devices in their cars.
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?
A case study in this chapter describes how a boyfriend can signal his love to a girlfriend by giving an appropriate gift. Do you think saying "I love you" can also serve as a signal? Why or why not?
The health insurance reform signed into law by President Obama in 2010 included the following two provisions:
i. Insurance companies must offer health insurance to everyone who applies and charge them the same price regardless of a person's preexisting health condition.
ii. Everyone must buy health insurance or pay a penalty for not doing so.
a. Which of these policies taken on its own makes the problem of adverse selection worse? Explain.
b. Why do you think the policy you identified in part (a) was included in the law?
c. Why do you think the other policy was included in the law?
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.)
Three friends are choosing a restaurant for dinner. Here are their preferences:
a. If the three friends use a Borda count to make their decision, where do they go to eat?
b. On their way to their chosen restaurant, they see that the Mexican and French restaurants are closed, so they use a Borda count again to decide between the remaining two restaurants. Where do they decide to go now?
c. How do your answers to parts (a) and (b) relate to Arrow's impossibility theorem?
Three friends are choosing a TV show to watch. Here are their preferences:
a. If the three friends try using a Borda count to make their choice, what would happen?
b. Monica suggests a vote by majority rule. She proposes that first they choose between $Empire$ and
$Supergirl,$ and then they choose between the winner of the first vote and Homeland. If they all vote their preferences honestly, what outcome would occur?
c. Should Chandler agree to Monica's suggestion? What voting system would he prefer?
d. Phoebe and Monica convince Chandler to go along with Monica's proposal. In round one, Chandler dishonestly says he prefers $Supergirl$ over $Empire$. Why might he do this?
Five roommates are planning to spend the weekend in their dorm room watching movies, and they are debating how many movies to watch. Here is their willingness to pay:
Buying a DVD costs \$15, which the roommates split equally, so each pays \$3 per movie.
a. What is the efficient number of movies to watch (that is, the number that maximizes total surplus)?
b. From the standpoint of each roommate, what is the preferred number of movies?
c. What is the preference of the median roommate?
d. If the roommates held a vote on the efficient outcome versus the median voter's preference, how would each person vote? Which outcome would get a majority?
e. If one of the roommates proposed a different number of movies, could his proposal beat the winner from part (d) in a vote?
f. Can majority rule be counted on to reach efficient outcomes in the provision of public goods?
Two ice-cream stands are deciding where to set up along a 1-mile beach. The people are uniformly located along the beach, and each person sitting on the beach buys exactly 1 ice-cream cone per day from the nearest stand. Each ice-cream seller wants the maximum number of customers. Where along the beach will the two stands locate? Of which result in this chapter does this outcome remind you?
The government is considering two ways to help the needy: giving them cash or giving them free meals at soup kitchens.
a. Give an argument, based on the standard theory of the rational consumer, for giving cash.
b. Give an argument, based on asymmetric information, for why the soup kitchen may be better than the cash handout.
c. Give an argument, based on behavioral economics, for why the soup kitchen may be better than the cash handout.