Question 1

Suppose an insurance company decided to offer divorce insurance. Based on the concept of moral hazard, economists would expect

Accepted Answer

The concept of moral hazard suggests that individuals with insurance may take more risks since they are protected from the negative consequences. In the case of divorce insurance, this means that couples with marital problems may be more likely to purchase the insurance since they feel protected from the financial consequences of divorce. Therefore, mostly the couples with marital problems would be expected to purchase divorce insurance.

Question 2

As it applies to insurance, the adverse selection problem is the tendency for

Accepted Answer

The adverse selection problem is the tendency for individuals who are most likely to file a claim to purchase insurance. This is because they have a higher perceived risk of loss and stand to gain more from insurance coverage. This can lead to higher costs for the insurer and potentially lead to the insurer offering less coverage or higher premiums to compensate for the increased risk of paying out claims.

Question 3

Upon learning that his auto transmission is about to fail, Ray sells his car to an unsuspecting buyer. This circumstance illustrates the

Accepted Answer

The adverse selection problem occurs when one party has more information than the other party in a transaction, leading to an uneven distribution of information. In this scenario, Ray has information about the failing transmission that the buyer does not, leading to an unfair advantage for Ray and a potentially detrimental outcome for the buyer.

Question 4

Some sellers of used cars provide warranties to buyers, with the aim of reassuring buyers that the car is of good quality. These warranties help reduce the chance of what occurring?

Accepted Answer

Warranties on used cars help mitigate adverse selection by assuring buyers of the quality of the car, reducing the risk of purchasing a low-quality vehicle unknowingly. Adverse selection occurs when there is asymmetric information between buyers and sellers, leading to the market being dominated by lower-quality goods.

Question 5

In response to the 2008 financial crisis, the government began to bail out banks deemed "too big to fail." Critics of this action argued that this would create the prospect of future bailouts and encourage banks to be fiscally irresponsible in the future. This illustrates

Accepted Answer

The moral hazard problem occurs when one party takes more risks because they know another party bears the cost of those risks. In this case, banks might engage in riskier behavior knowing they would likely be bailed out by the government, which is a classic example of moral hazard.

Question 6

Professional buyers of antiques often have more information about the value of antique objects than do the sellers. This illustrates

Accepted Answer

This situation exemplifies the concept of asymmetric information, in which one party in a transaction possesses more or better information relevant to the transaction than the other party. In this case, the professional buyers have access to more information about the value of the antiques than do the sellers.

Question 7

Where there is asymmetric information between buyers and sellers,

Accepted Answer

Asymmetric information between buyers and sellers can lead to markets producing inefficient outcomes because one party has more or better information than the other, affecting the quality and fairness of transactions.

Question 8

In a television advertisement for AFLAC supplemental health insurance, an ice skater says to his skating partner, "Do you want to try a triple jump?" She responds, "Why not, I have AFLAC." This response illustrates the

Accepted Answer

The response illustrates the moral hazard problem, which occurs when a person takes more risks because they are protected from the consequences, in this case, by having AFLAC supplemental health insurance.

Question 9

Upon buying a car with airbags, Indy begins to drive recklessly. This is an example of the

Accepted Answer

This scenario is an example of the moral hazard problem, as Indy's behavior changes in response to the increased safety provided by the airbags. He is more willing to take risks while driving because he feels protected by the airbags, which in turn increases the likelihood of an accident.

Question 10

A competitive market produces the economically efficient outcome if the following conditions are met, except

Accepted Answer

Options A and D are essentially stating the same principle but in reverse order, indicating a redundancy rather than an exception to the conditions for economic efficiency in a competitive market. The economically efficient outcome is achieved when the benefits of producing a unit are at least equal to the costs of producing it, which is what both A and D describe. However, the question asks for an exception to the conditions for economic efficiency, making D the incorrect choice because it does not serve as an exception but rather restates a condition similar to A.

Question 11

Sellers will opt out of markets in which

Accepted Answer

Sellers may opt out of markets where information about buyers is inadequate, as this can lead to situations where some buyers impose high costs on the sellers, making the market less attractive or profitable for them.

Question 12

As it applies to insurance, the moral hazard problem is the tendency for

Accepted Answer

The moral hazard problem refers to the increased risk-taking behavior of insured individuals, who are less likely to take precautions to avoid the insured risk because they know they are protected by insurance. This can lead to higher claims and higher premiums for all consumers. Choice A is the adverse selection problem, where those most likely to benefit from insurance are more likely to buy it.

Choices C and D are unrelated to the concept of moral hazard in insurance.

Question 13

TripAdvisor provides online reviews of hotels, restaurants, and attractions at tourist destinations around the world. When a traveler is planning a vacation, TripAdvisor helps the traveler avoid

Accepted Answer

TripAdvisor helps travelers avoid adverse selection by providing information and reviews about hotels, restaurants, and attractions to help them make more informed decisions. Adverse selection occurs when one party in a transaction has more information than the other, leading to potentially negative outcomes for the less-informed party. In this case, TripAdvisor is helping to reduce the information asymmetry between travelers and travel-related businesses, which can lead to better outcomes for both parties.

Question 14

In a cap-and-trade program,

Accepted Answer

In a cap-and-trade program, the government sets a limit (cap) on the total amount of a pollutant that can be emitted. Companies are issued permits that allow them to emit a certain amount of that pollutant. If they need to emit more, they must buy permits from other companies who have excess. This system incentivizes reducing emissions, as companies can sell their unused permits to others.

Question 15

A cap-and-trade program

Accepted Answer

A cap-and-trade program assigns a property right to polluting the atmosphere by allowing firms to buy and sell emission permits, thus creating a market for pollution rights.

Question 16

Suppose a firm offers its workers a cafeteria plan in which it allows workers to allocate a set amount of fringe benefit money toward specific insurance. Mary, who has five kids needing braces, selects the family dental coverage. This is an example of the

Accepted Answer

The choice of family dental coverage by Mary, who has a higher than average need for dental services due to her five kids needing braces, is an example of the adverse selection problem. Adverse selection occurs when one party in a transaction has more information than the other, typically leading to a situation where the party with more information selects goods or services that benefit them at the expense of the other party. In this case, the insurance provider faces the risk of loss due to not being able to accurately price the insurance because of not knowing individual needs beforehand.

Question 17

Buyers will opt out of markets in which

Accepted Answer

Buyers will opt out of markets where there is inadequate information about sellers and their products because they cannot make informed purchasing decisions, leading to uncertainty and potential risk.

Question 18

Product reviews help to alleviate problems associated with

Accepted Answer

Product reviews provide potential buyers with more information about a product, which helps to reduce the asymmetry of information between buyers and sellers. Asymmetric information can lead to market failures, such as the lemons problem, where the presence of poor quality products drives out higher quality products because buyers cannot distinguish between them. Product reviews can help to signal the quality of a product and alleviate this problem.

Question 19

Owners of defective used cars have more information about the condition of their vehicles than potential buyers of those used cars. This is an example of

Accepted Answer

The scenario described involves asymmetric information, where one party (the owner of the defective used car) has more information than another party (potential buyers). This can lead to a market failure, as potential buyers may not be willing to pay the true value of the car due to uncertainty about its condition.

Question 20

Because the federal government typically provides disaster relief to farmers, many farmers do not buy crop insurance even through it is federally subsidized. This illustrates

Accepted Answer

The fact that farmers rely on federal disaster relief and do not buy federally subsidized crop insurance suggests the presence of moral hazard. Moral hazard occurs when individuals or organizations change their behavior after obtaining insurance, taking on riskier investments or behaviors because they feel protected by the insurance. In this case, the federal government's provision of disaster relief may be encouraging farmers to take on riskier crop choices and planting decisions, as they feel protected against losses.

Quiz 4: Market Failures Caused by Externalities Asymmetric Information