Chapter 24, Problem 1FT

Sub part (a):

To determine

Whether the situations represent problems caused by asymmetric information, moral hazard, or adverse selection.

Explanation of Solution

The market is a structure where there are buyers who buy and sellers who sell and there is an exchange of goods and services between them. Price is determined by the interaction of the demand and supply in the market.  Sometimes, price acts as market signals as they will passively pass the information about the scarcity of the commodity (and related needs) to conserve the commodity. The market price also signals about the condition as well as the nature of the commodity traded.

When there is unrest in the Middle East and the speculators are buying up the oil from the Middle East to earn higher profits in the future, the demand for oil would increase. This increase in demand would lead to a higher increase in the price of oil. This cannot be considered as an example for asymmetric information because all the speculators have equal information about the future; no one has any additional information.

Economics Concept Introduction

Concept introduction:

Market signal: It refers to the unintentional or passive passage of information between the participants of the market.

Asymmetric information: The problem of asymmetric information emerges when there is a difference in the degree of information in the market. The asymmetric information leads to wrong choices by the consumer. The problems caused due to the asymmetric information are adverse selection and moral hazard.

Moral hazard: A moral hazard is a problem that arises due to the insurance sector. When one is insured against the loss of wealth or health, they will have a lax attitude towards the same; this would increase the chances for falling ill or losing wealth because they know that the insurance companies will bear their loss and repay them for the same.

Adverse selection: Adverse selection is a prominent problem in the market for second-hand cars. Asymmetric information leads the buyers to select the bad lemons (bad cars) from the market instead of good cherries (good cars).

Sub part (b):

To determine

Whether the situations represent problems caused by asymmetric information, moral hazard, or adverse selection.

Explanation of Solution

When the individual forgets to lock the door of the house and decides to let it be because of the insurance that the individual has on the house and its belongings, it means that the individual is careless to protect the house and wealth. The individual has more information about the situation than the insurance company, which bears the risk. Thus, there is asymmetric information problem. This carelessness comes from the insurance and, thus, it is an example of a moral hazard.

Economics Concept Introduction

Concept introduction:

Market signal: It refers to the unintentional or passive passage of information between the participants of the market.

Asymmetric information: The problem of asymmetric information emerges when there is a difference in the degree of information in the market. The asymmetric information leads to wrong choices by the consumer. The problems caused due to the asymmetric information are adverse selection and moral hazard.

Moral hazard: A moral hazard is a problem that arises due to the insurance sector. When one is insured against the loss of wealth or health, they will have a lax attitude towards the same; this would increase the chances for falling ill or losing wealth because they know that the insurance companies will bear their loss and repay them for the same.

Adverse selection: Adverse selection is a prominent problem in the market for second-hand cars. Asymmetric information leads the buyers to select the bad lemons (bad cars) from the market instead of good cherries (good cars).

Sub part (c):

To determine

Whether the situations represent problems caused by asymmetric information, moral hazard, or adverse selection.

Explanation of Solution

The applicant has higher degrees of qualifications than the others, but the firm selects the wrong person for the post of the part-time manager in the restaurant. This means that the firm selects an applicant who does not have a degree and rejects applicants with an MBA. This shows the problem of adverse selection. There is also a chance that the manager of the restaurant thinks that a MBA applicant for the job in a restaurant means that the applicant is not a talented businesswoman. Either way, it represents the issue of adverse selection.

Economics Concept Introduction

Concept introduction:

Market signal: It refers to the unintentional or passive passage of information between the participants of the market.

Asymmetric information: The problem of asymmetric information emerges when there is a difference in the degree of information in the market. The asymmetric information leads to wrong choices by the consumer. The problems caused due to the asymmetric information are adverse selection and moral hazard.

Moral hazard: A moral hazard is a problem that arises due to the insurance sector. When one is insured against the loss of wealth or health, they will have a lax attitude towards the same; this would increase the chances for falling ill or losing wealth because they know that the insurance companies will bear their loss and repay them for the same.

Adverse selection: Adverse selection is a prominent problem in the market for second-hand cars. Asymmetric information leads the buyers to select the bad lemons (bad cars) from the market instead of good cherries (good cars).

Sub part (d):

To determine

Whether the situations represent problems caused by asymmetric information, moral hazard, or adverse selection.

Explanation of Solution

The smell from the restaurant to the apartment is an example of a negative externality. The actions of the restaurant owner increase the cost of the apartment owner. There is no information asymmetry in the market, which means that the case is not an example for asymmetric information.

Economics Concept Introduction

Concept introduction:

Market signal: It refers to the unintentional or passive passage of information between the participants of the market.

Asymmetric information: The problem of asymmetric information emerges when there is a difference in the degree of information in the market. The asymmetric information leads to wrong choices by the consumer. The problems caused due to the asymmetric information are adverse selection and moral hazard.

Moral hazard: A moral hazard is a problem that arises due to the insurance sector. When one is insured against the loss of wealth or health, they will have a lax attitude towards the same; this would increase the chances for falling ill or losing wealth because they know that the insurance companies will bear their loss and repay them for the same.

Adverse selection: Adverse selection is a prominent problem in the market for second-hand cars. Asymmetric information leads the buyers to select the bad lemons (bad cars) from the market instead of good cherries (good cars).

Sub part (e):

To determine

Whether the situations represent problems caused by asymmetric information, moral hazard, or adverse selection.

Explanation of Solution

Since the potential cost of long-term care is very high and the private market for the long term care remains fairly small, it means that there exists an information asymmetry between the players in the market. This is an example for the adverse selection issue because it is hard to grow the market when the people most interested in the insurance products are those most likely to need it and make the claims.

Economics Concept Introduction

Concept introduction:

Market signal: It refers to the unintentional or passive passage of information between the participants of the market.

Asymmetric information: The problem of asymmetric information emerges when there is a difference in the degree of information in the market. The asymmetric information leads to wrong choices by the consumer. The problems caused due to the asymmetric information are adverse selection and moral hazard.

Moral hazard: A moral hazard is a problem that arises due to the insurance sector. When one is insured against the loss of wealth or health, they will have a lax attitude towards the same; this would increase the chances for falling ill or losing wealth because they know that the insurance companies will bear their loss and repay them for the same.

Adverse selection: Adverse selection is a prominent problem in the market for second-hand cars. Asymmetric information leads the buyers to select the bad lemons (bad cars) from the market instead of good cherries (good cars).