For each of the following situations, do the following: first describe whether i

Question

For each of the following situations, do the following: first describe whether it is a situ- ation of moral hazard or of adverse selection. Then explain what inefficiency can arise from this situation and explain how the proposed solution reduces the inefficiency. a. When you buy a second-hand car, you do not know whether it is a lemon (low quality) or a plum (high quality), but the seller knows. A solution is for sellers to offer a warranty with the car that pays for repair costs b. Some people are prone to see doctors unnecessarily for minor complaints like headaches, and health maintenance organizations do not know how urgently you need a doctor. A solution is for insurees to have to make a co-payment of a cer tain dollar amount (for example, $10) each time they visit a health care provider. All insurees are risk-averse. c. When ail tickets, they do not know whether a buyer is a business traveler (who is willing to pay a lot for a seat) or a leisure traveler (who has a low willing ness to pay). A solution for a profit-maximizing airline is to offer an expensive ticket that is very flexible (it allows date and route changes) and a cheap ticket that is very inflexible (it has to be booked in advance and cannot be changed). d. A company does not know whether workers on an assembly line work hard or whether they slack off. A solution is to pay the workers "piece rates," that is, pay them according to how much they have produced each day. All workers are risk- averse, but the company is not risk-neutral e. When making a decision about hiring you, prospective employers do not know whether you are a productive or unproductive worker. A solution is for productive workers to provide potential employers with references from previous employers

Explanation / Answer

a)

Adverse selection

Inefficiency: The buyer might end up purchasing a poor-quality car

How solution can help: It will assure the buyer of the good quality of the car, since seller is taking responsibility of its performance

b)

Moral Hazard

Inefficiency: The insuree might end up making a lot of visits to doctor

How solution can help: The copayment amount will deter the insure from going to the doctor too frequently

c)

Adverse selection

Inefficiency: The airlines are not aware which person has how much willingness to pay and might end up giving low priced seats to travelers with high willingness to pay

How solution can help: It will ensure that only business travelers pay for expensive flights as they are more flexible in their travel time

d)

Adverse selection

Inefficiency: The employer might end up hiring unproductive workers

How solution can help: It will assure the employer of the performance and work history record of the worker

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