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Chapter 4: Q6. (page 93)

People drive faster when they have auto insurance. This example illustrates

  1. adverse selection.
  2. asymmetric information.
  3. moral hazard.

Short Answer

Expert verified

Option (c): Moral hazard

Step by step solution

01

Step 1. People driving faster after getting auto insurance

People drive faster after getting auto insurance is a problem of moral hazard. Moral hazard refers to the problem of asymmetric information that results in a cost for one party due to the other party's actions that occur after a contract/agreement or market exchange.

People know any accidents that could damage the vehicle will be covered by the insurance company, and therefore, they can choose to drive faster. The outcome of the bad decisions will put a cost on the insurance company that they did not know when selling the insurance.

02

Step 2. Reasons for incorrect options

Adverse selection is the problem of lemons. This happens when one party is unaware of certain information about the other party before entering into a contract or market exchange. This leads to a selection of bad goods or services, which are referred to as lemons. Since driving faster happens after buying auto insurance, this is not a part of the adverse selection problem.

Asymmetric information problems can result in both adverse selection and moral hazard depending on the reason and time of generation of cost for one party due to another party. Moral hazard is a more precise answer.

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Most popular questions from this chapter

Use marginal cost-marginal benefit analysis to determine if the following statement is true or false: “The optimal amount of pollution abatement for some substances, say dirty water from storm drains, is very low; the optimal amount of abatement for other substances, say cyanide poison, is close to 100 percent.”

Refer to Tables 4.1 and 4.2, which show, respectively, the willingness to pay and the willingness to accept of buyers and sellers of bags of oranges. For the following questions, assume that the equilibrium price and quantity depend on the following changes in supply and demand. Also assume that the only market participants are those listed by name in the two tables.

a. What are the equilibrium price and quantity for the data displayed in the two tables?

b. Instead of bags of oranges, assume that the data in the two tables deal with a good (such as firework display) that can be enjoyed by free riders who do not pay for it. If all the buyers in the two tables free ride, what quantity will private sellers supply?

c. Assume that we are back to talking about bags of oranges (a private good), but the government has decided that tossed orange peels impose a negative externality on the public that must be rectified by imposing a \(2-per-bag tax on sellers. What is the new equilibrium price and quantity? If the new equilibrium quantity is the optimal quantity, by how many bags were oranges overproduced before?

PersonMaximum price willing to pay (\))
Bob
13
Barb12
Bill11
Bart10
Brent9
Betty8
PersonMinimum acceptable price ($)
Carlos3
Courtney4
Chuck5
Cindy6
Craig7
Chad8

True or False: A market may collapse and have relatively few transactions between buyers and sellers if buyers have more information than sellers.

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.”

  1. Suppose that there are equal numbers of good and bad used cars in the market. Good used cars are worth 13,000,andbadusedcarsareworth5,000. What is the average value of a used car?
  2. 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?
  3. Would a potential seller of a good used car be willing to accept the average value as payment for the vehicle?
  4. 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?
  5. Will the used-car market come to feature mostly—if not exclusively—lemons? Explain. How much will used cars end up costing if all the good cars are withdrawn from the market?

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 information asymmetry likely to increase or decrease the insurance premium? Why?
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