SM14ce Micro Chap004A.doc

Chapter 04 Appendix Chapter 04 Appendix McConnell Brue Flynn Barbiero Micro 14ce APPENDIX DISCUSSION QUESTIONS 1. Because medical records are private, an individual applying for health insurance will know more about his own health conditions than will the insurance companies to which he is applying for coverage. Is this likely to increase or decrease the insurance premium that he will be offered? Why? LOA4.1 Answer: This will likely increase the insurance premium because the buyers of the insurance policy have more information about their health status than the sellers (the insurance companies). Because of this asymmetric information problem insurance companies will likely suffer losses if they charge an insurance premium based on the average health of the population. Only the unhealthy will purchase coverage at this 'average' price. These potential losses will force insurance companies to charge a higher premium, on average, than they would if they had complete information. 2. Why is it in the interest of new homebuyers and builders of new homes to have government building codes and building inspectors? LOA4.1 Answer: The reason is related to the lack of information and education on the part of most new homebuyers and builders with regard to every aspect of home construction. To make sure that a new building conforms to adequate safety and construction standards, building codes have been created. The government inspectors provide impartial thirdparty expertise to assure the buyer that the codes have been met. Such inspections also provide information to builders about the electrical and plumbing installation that is usually done by subcontractors. Without building codes and inspections, the market for new homes might be severely hampered. Builders thus also benefit from codes and inspectors. 3. Place an “M” beside the items in the following list that describe a moral hazard problem and an “A” beside those that describe an adverse selection problem. LOA4.1 a. A person with a terminal illness buys several life insurance policies through the mail. b. A person drives carelessly because she has automobile insurance. c. A person who intends to torch his warehouse takes out a large fire insurance policy. d. A professional athlete who has a guaranteed contract fails to stay in shape during the off-season. e. A woman who anticipates having a large family takes a job with a firm that offers exceptional childcare benefits. Answer: (a) This is an adverse selection problem. The buyer of the insurance policy has more information about his or her health than the seller when the contract is signed. (b) This is a moral hazard problem. The person changes their behavior after the insurance contract is signed. (c) This is an adverse selection problem. The buyer of the insurance policy has more information about the likelihood of a fire (intentional) than the seller when the contract is signed. (d) This is a moral hazard problem. The person changes his or her behavior after the contract is signed. (e) This is an adverse selection problem. The woman has more information about her desired family size when the firm hires her. APPENDIX REVIEW QUESTIONS 1. People drive faster when they have auto insurance. This is an example of: LOA4.1 a. Adverse selection. b. Asymmetric information. c. Moral hazard. Answer: c, Moral hazard People driving faster when they have auto insurance is an example of moral hazard. This is true because moral hazard is the tendency of one party to a contract or agreement to alter her or his behavior, after the contract is signed, in ways that could be costly to the other party. In this case, drivers who have signed auto insurance contracts alter their driving behavior in a way that is likely to be very costly to the insurance companies, who will have to pay for any increase in the number of accidents that is caused by their customers driving faster. 2. Government inspectors who check on the quality of services provided by retailers as well as government requirements for licensing in various professions are both attempts to resolve: LOA4.1 a. The moral hazard problem. b. The asymmetric information problem. Answer: b, the asymmetric information problem. This is true because the government inspectors and professional licensing are attempts to reassure consumers that they do not have to worry about the quality of the services they are buying. This reassurance helps to facilitate trade because, without it, many consumers would refuse to purchase such services out of the fear that they would be dealing with an incompetent or dishonest seller. 3. True or False: A market may collapse and have relatively few transactions between buyers and sellers if buyers have more information than sellers. LOA4.1 Answer: True This statement is true because when buyers have more information than sellers, sellers must worry that buyers will take advantage of them. The standard example of this phenomenon is health insurance, because individuals almost always have better information about their own health conditions than insurance companies. This causes a pricing problem for the insurance companies, who would like to keep the cost of insurance low so that it will be widely popular with all sorts of people. But the people most likely to want to buy health insurance are people who know that they are sicker than average and will very likely need a lot of costly treatments in the future. Taking that into consideration, the health insurance companies must raise the price of insurance so as to make sure that they will be collecting enough in premiums to be able to cover those high future costs. But as the price of insurance rises, a lot of healthy people will no longer find it worth their while to buy health insurance. As they drop out of the market, the group of people still buying insurance comes to be dominated by the people who privately know that they are more costly than average. As a result, the market may collapse as many who would have bought insurance at lower prices now choose to go without. APPENDIX PROBLEMS 1. Consider a used-car market with asymmetric information. The owners of used cars know what their vehicles are worth but have no way of credibly demonstrating those values to potential buyers. Thus, potential buyers must always worry that the used car they are being offered may be a low-quality “lemon.” LOA4.1 a. Suppose that there are equal numbers of good and bad used cars in the market and that good used cars are worth $13,000 while bad used cars are worth $5,000. What is the average value of a used car? b. By how much does the average value exceed the value of a bad used car? By how much does the value of a good used car exceed the average value? c. Would a potential seller of a good used car be willing to accept the average value as payment for her vehicle? d. If a buyer negotiates with a seller to purchase the seller’s used car for a price equal to the average, is the car more likely to be good or bad? e. Will the used-car market come to feature mostly, if not exclusively, lemons? How much will used cars end up costing if all the good cars are withdrawn? Answer: (a) $9,000; (b) By $4,000; $4,000; (c) No; (d) Bad; (e) Yes; $5,000 each Feedback: Consider the following example for the different parts below. Part a: Suppose that there are equal numbers of good and bad used cars in the market and that good used cars are worth $13,000 while bad used cars are worth $5,000. What is the average value of a used car? Since there are an equal number of good and bad used cars in the market the likelihood of each type is 0.50 (or 50% good and 50% bad)). This implies the average value of a used car is $9000 (=0.5 x $13,000 + 0.5 x $5,000). You can also find the average by adding together the two values ($13,000 + $5,000) and dividing by two = $18,000/2 = $9,000. Part b: By how much does the average value exceed the value of a bad used car? By how much does the value of a good used car exceed the average value? The average value of a used car exceeds the value of a bad used car by $4,000 (=$9,000-$5,000). The value of a good used car exceeds the average value a used car by $4,000 (=$13,000-$9,000). Part c: No, the typical buyer would NOT be willing to pay the average value as there is a 50 percent chance that they are not getting the full value of the car. Part d: If a buyer negotiates with a seller to purchase the seller’s used car for a price equal to the average value, is the car more likely to be good or bad? The car will likely be a bad used car with a value of $5,000. The seller of a good used car is unlikely to accept $9,000 (average value) for a car worth $13,000 (value of a good used car). Part e: Will the used car market come to feature mostly—if not exclusively—lemons? How much will used cars end up costing if that all the good cars are withdrawn? Yes, this market will come to feature mostly, if not exclusively, lemons. If all the good cars are withdrawn, the remaining bad cars should go for what they are worth, $5,000 each. 4A-1 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.