Key Concepts

Discussion and Review Questions

Learning Objective 20.1 Discover how sellers’ private information can reduce the quality of goods offered for sale and distort market outcomes.
  1. Go online to eBay, Craigslist, Amazon, or any other site where you can buy used products and find something you may be interested in purchasing. Does the seller have private information about the quality of the good? How much are you willing to pay for the product? Explain how the seller’s private information influences your willingness to pay. What are some strategies that you can use to determine the quality of the used product before you make a purchase?
  2. For each of the following, explain how it may serve as a possible solution to the private information problem in the used-home market.
    1. A home warranty contract.
    2. Hiring a home inspector who takes a careful look at the house’s structural integrity, plumbing, and electric circuits.
    3. Laws requiring sellers to disclose known defects.
Learning Objective 20.2 Discover how buyers’ private information can drive sellers’ costs and distort market outcomes.
  1. Consider the market for health insurance.
    1. Describe the concept of adverse selection as it relates to this market and explain why it may result in a “death spiral” in private markets.
    2. What are some possible steps the government might take to mitigate the market failure that could result from adverse selection?
    3. What steps could private insurance companies take in order to reduce the problems resulting from adverse selection?
Learning Objective 20.3 Recognize and solve problems that arise when some actions are hidden.
  1. Veronica manages a team of medical transcribers, who all work from home and are paid hourly. What potential problems might she have getting her remote team members to work as productively as she needs them to? What are some possible solutions?
  2. When you rent an apartment or house, most landlords will require that you pay a refundable security deposit. Why do you think landlords do this? Relate their actions to possible problems caused by moral hazard.

Study Problems

Learning Objective 20.1 Discover how sellers’ private information can reduce the quality of goods offered for sale and distort market outcomes.

  1. Jack is considering selling his elliptical machine, which he never really used, is high quality, and has been taking up space in his spare bedroom. He lists it on Facebook Marketplace for “$1,200 or best offer” but in reality won’t sell it for less than $1,000. Lina is looking to purchase a used elliptical machine. For a high-quality elliptical, she is willing to pay up to $1,300, and for a low-quality elliptical, she is willing to pay $600.

    Lina is risk neutral but she cannot tell if the elliptical machine is high quality or low quality. If she believes that 60% of used elliptical machines are high quality and 40% are low quality, what is the maximum price that Lina would be willing to pay? Would Jack agree to this price?

  2. Carfax is a service that supplies vehicle history reports on used cars, including their ownership history, mileage, and past accidents. The existence of Carfax as a third-party verifier in the used-car industry can result in which of the following? Choose any that apply.
    1. An increase in buyers’ willingness to pay for used cars.
    2. An increase in the number of cars available in the used-car market.
    3. A more efficient outcome in the used-car market.
  3. Sophia operates her own accounting practice and is looking to hire two entry-level accountants. A high-productivity worker will generate $90,000 in revenue per year and a low-productivity worker will generate $60,000. Tasia is a high-productivity worker and wants at least a salary of $80,000. Rick is a low-productivity worker and wants at least a $55,000 salary.
    1. If Sophia can identify Tasia’s and Rick’s productivity, who should she hire and what would her profits be?
    2. It’s more likely that Sophia can’t tell who will be a high- or low-productivity worker from an interview. But based on her experience, she believes that 65% of workers are low productivity and 35% of workers are high productivity. Find the maximum salary that she would be willing to pay and determine who will accept her job offer. Does this change the maximum she is willing to pay for an accountant of unknown quality?
    3. How do employers try to determine a job candidate’s productivity before hiring them?
Learning Objective 20.2 Discover how buyers’ private information can drive sellers’ costs and distort market outcomes.
  1. For each of the following scenarios, identify how it will likely reduce or increase the problems associated with adverse selection of buyers.
    1. Advances in technology make it less expensive for people to take a DNA test that provides them—but not their health insurer—with information about their risk of developing various diseases.
    2. The government mandates that all drivers must purchase auto insurance.
    3. Google decides to offer multiple health care plans to its employees. One plan offers a high deductible, but a low monthly premium. The other plan offers a low deductible, but a high monthly premium.
  2. Dalia owns a small public relations firm and wants to contract with her insurance provider to offer her employees the option to purchase short-term disability insurance. The insurance will pay out $5,000 to any worker who has to miss at least three consecutive weeks of work due to an illness or accident that occurred outside the work place. Her employees’ probabilities of using the insurance in any year are in the accompanying table.
    Employee Probability of using the insurance
         Carol 20%
         Jose 50%
         Fan 15%
         Andre 85%
         Birat 40%
    1. If the insurance company can easily figure out the probabilities of each employee using the short-term disability insurance, and it can tailor its price to each customer, what is the lowest price it’s willing to charge each person?
    2. Now suppose that each of Dalia’s employees knows their own probability of using the insurance, but the insurance company only knows that, on average, the probability of a worker suffering a qualifying injury or illness is about 40%. Based on this, how much on average does the insurance company expect to pay out per policy if everyone buys it?
    3. Who will purchase the insurance at the price you calculated in part (b) and how much expected profit will the insurance company earn?
    4. How much will the insurance company need to increase the premium it charges to each person in order to avoid making a loss? Who will continue to buy the insurance and how much profit will the insurance company now earn?
    5. How much will the insurance company need to increase the premium charged to each person in order to earn zero profits? Who will continue to buy the insurance?
    6. What is happening to the size of the insured population? What is this called?
Learning Objective 20.3 Recognize and solve problems that arise when some actions are hidden.
  1. You are working at a marketing firm in ad sales. Your manager announces that the company is starting a new incentive program to increase the number of potential customers, or leads, for salespeople to contact. For every lead submitted by an employee, the employee will receive $10 in their next paycheck.

    After a week, the sales manager realizes that her staff is simply submitting lists of names of everyone they know for $10 a name, resulting in a net loss to the company because the vast majority of the leads are useless. For each of the following changes, explain to your manager whether or not it will fix the problem.

    1. Instead of offering $10 for each lead, offer $25 instead.
    2. Instead of offering $10 for each lead, offer $5 instead.
    3. Instead of paying $10 for each lead, offer to pay employees a percentage of revenue actually earned from a lead they submit.
    4. Hire a consultant to sift through the leads and only pass along useful leads to the sales team.
  2. For each of the following scenarios, identify whether it is an example of adverse selection of sellers, adverse selection of buyers, or moral hazard. Come up with a possible solution to each problem.
    1. You hire your neighbor to check on your cat every day while you are traveling for the week. The neighbor checks on your cat every other day instead.
    2. Your local seafood shop advertises fresh seafood, but you are not certain if the seafood is actually fresh or if it has been frozen.
    3. People with asthma are more likely to buy health insurance.