Chapter 17, Markets with Asymmetric Information Video Solutions, Microeconomics

Problem 1

Many consumers view a well-known brand name as a signal of quality and will pay more for a brand-name product (e.g., Bayer aspirin instead of generic aspirin, or Birds Eye frozen vegetables instead of the supermarket's own brand). Can a brand name provide a useful signal of quality? Why or why not?

Brandon Miskanic

Numerade Educator

02:18

Problem 2

Cary is a recent college graduate, After six months at his new job, he has finally saved enough to buy his first car.
a. Gary knows very little about the difference between makes and models. How could he use market signals, reputation, or standardization to make comparisons?
b. You are a loan officer in a bank. After selecting a car, Gary comes to you seeking a loan. Because he has only recently graduated, he does not have a long credit history. Nonetheless, the bank has a long history of financing cars for recent college graduates. Is this information useful in Gary's case? If so, how?

Sheryl Ezze

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02:50

Problem 3

A major university bans the assignment of $D$ or $F$ grades. It defends its action by claiming that students tend to perform above average when they are free from the pressures of flunking out. The university states that it wants all its students to get As and Bs. If the goal is to raise overall grades to the B level or above, is this a good policy? Discuss this policy with respect to the problem of moral hazard.

Jennifer Stoner

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01:54

Problem 4

Professor Jones has just been hired by the economics department at a major university. The president of the board of regents has stated that the university is committed to providing top-quality education for undergraduates. Two months into the semester, Jones fails to show up for his classes. It seems he is devoting all his time to research rather than to teaching. Jones argues that his research will bring prestige to the department and the university. Should he be allowed to continue exclusively with research? Discuss with reference to the principal-agent problem.

Shiksha Dutta

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02:19

Problem 5

Faced with a reputation for producing automobiles with poor repair records, a number of American companies have offered extensive guarantees to car purchasers (e.g., a seven-year warranty on all parts and labor associated with mechanical problems).
a. In light of your knowledge of the lemons market, why is this a reasonable policy?
b. Is the policy likely to create a moral hazard probIem? Explain.

Luis Fernando Olloqui Regalado

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04:25

Problem 6

To promote competition and consumer welfare, the Federal Trade Commission requires firms to advertise truthfully. How does truth in advertising promote competition? Why would a market be less competitive if firms advertised deceptively?

Puneet Prajapati

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02:48

Problem 7

An insurance company is considering issuing three types of fire insurance policies: (i) complete insurance coverage, (ii) complete coverage above and beyond a $\$ 10,000$ deductible, and (iii) 90 percent coverage of all losses. Which policy is more likely to create moral hazard problems?

Christopher Stanley

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01:48

Problem 8

You have seen how asymmetric information can reduce the average quality of products sold in a market, as low-quality products drive out high-quality products. For those markets in which asymmetric information is prevalent, would you agree or disagree with each of the following? Explain briefly:
a. The government should subsidize Consumer Reports.
b. The government should impose quality standards
e.g.r, firms should not be allowed to sell low-quality items.
c. The producer of a high-quality good will probably want to offer an extensive warranty.
d. The government should require all firms to offer extensive warranties.

Daniel Cisneros

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07:13

Problem 9

Two used car dealerships compete side by side on a main road. The first, Harry's Cars, always sells high quality cars that it carefully inspects and, if necessary, services. On average, it costs Harry's $\$ 8000$ to buy and service each car that it sells. The second dealership, Lew's Motors, always sells lower-quality cars. On average, it costs Lew's only $\$ 5000$ for each car that it sells. If consumers knew the quality of the used cars they were buying, they would pay $\$ 10,000$ on average for Harry's cars and only $\$ 7000$ on average for Lew's cars.
Without more information, consumers do not know the quality of each dealership's cars. In this case, they would figure that they have a $50-50$ chance of ending up with a high-quality car and are thus willing to pay $\$ 8500$ for a car.
Harry has an idea: He will offer a bumper-to bumper warranty for all cars that he sells. He knows that a warranty lasting $Y$ years will cost $\$ 500 Y$ on average, and he also knows that if Lew tries to offer the same warranty, it will cost Lew $\$ 1000 Y$ on average.
a. Suppose Harry offers a one-year warranty on all of the cars he sells.
i. What is Lew's profit if he does not offer a oneyear warranty? If he does offer a one-year warranty?
ii. What is Harry's profit if Lew does not offer a one-year warranty? If he does offer a one-year warranty?
iii. Will Lew's match Harry's one-year warranty?
iv. Is it a good idea for Harry to offer a one-year warranty?
b. What if Harry offers a two-year warranty? Will this offer generate a credible signal of quality? What about a three-year warranty?
c. If you were advising Harry, how long a warranty would you urge him to offer? Explain why.

Jesse Neumann

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00:01

Problem 10

As chairman of the board of ASP Industries, you estimate that your annual profit is given by the table below. Profit (II) is conditional upon market demand and the effort of your new CEO. The probabilities of each demand condition occurring are also shown in the table.
You must design a compensation package for the CEO that will maximize the firm's expected profit. While the firm is risk neutral, the CEO is risk averse. The CEO's utility function is
Utility $=W^{5}$ when making low effort Utility $=W^{5}-100$ when making high effort
where $W$ is the CEO's income. (The -100 is the "utility cost" to the CEO of making a high effort.) You know the CEO's utility function, and both you and the CEO know all of the information in the preceding table. You do not know the level of the CEO's effort at time of compensation or the exact state of demand. You do see the firm's profit, however.
Of the three alternative compensation packages below, which do you as chairman of ASP Industries prefer? Why?
Package 1: Pay the CEO a flat salary of $\$ 575,000$ per year Package 2 : Pay the CEO a fixed 6 percent of yearly firm profits Package
3: Pay the CEO a flat salary of $\$ 500,000$ per year and then 50 percent of any firm profits above $\$ 15$ million

Oluwadamilola Ameobi

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02:44

Problem 11

A firm's short-run revenue is given by $R=10 e-e^{2}$ where $e$ is the level of effort by a typical worker (all workers are assumed to be identical). A worker chooses his level of effort to maximize wage less effort $w-e$ (the per-unit cost of effort is assumed to be 1 ). Determine the level of effort and the level of profit (reventue less wage paid) for each of the following wage arrangements. Explain why these different principalagent relationships generate different outcomes.
a. $w=2$ for $e \geq 1$; otherwise $w=0$
b. $w=R / 2$
$\mathbf{c}, w=R-12.5$

Niamat Khuda

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02:57

Problem 12

UNIVERSAL SAVINGS \& LOAN has $\$ 1000$ to lend. Risk-free loans will be paid back in full next year with $4 \%$ interest. Risky loans have a $20 \%$ chance of defaulting (paying back nothing) and an $80 \%$ chance of paying back in full with $30 \%$ interest.
a. How much profit can the lending institution expect to earn? Show that the expected profits are the same whether the lending institution makes risky or riskfree loans.
b. Now suppose that the lending institution knows that the government will "bail out" UNIVERSAL if there is a default (paying back the original $\$ 1000$ ). What type of loans will the lending institution choose to make? What is the expected cost to the government?
c. Suppose that the lending institution doesn't know for sure that there will be a bail out, but one will occur with probability $P$, For what values of $P$ will the lending institution make risky loans?

James Kiss

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