Economics Week 1: Asymmetric Information

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Questions and Answers

What is a consequence of information asymmetry in the car market?

High-quality cars may be driven out of the market. (correct)

All cars are sold at their true market value.

Buyers are willing to pay only a premium price.

Sellers are more likely to charge higher prices.

In the principal-agent game, what does the agent decide?

The level of effort to exert. (correct)

The final outcome of the project.

The compensation structure of the principal.

The terms of the contract.

What does the effort subgame in the principal-agent game address?

Agent's effort versus principal's compensation.

Nature's impact on the project outcome.

Principal's decision on offering a bonus.

Agent's incentive compatibility constraint. (correct)

What is a potential outcome of adverse selection in a market?

Sellers may withdraw from the market due to low prices. Signup and view all the answers

How is Nash equilibrium applied in the context of the principal-agent game?

By finding a stable outcome where neither the principal nor agent benefits from changing their strategy. Signup and view all the answers

What issue may arise when contracting out services to the private sector?

Lower public costs with potentially worse outcomes Signup and view all the answers

Which of the following is NOT one of the challenges in measuring preferences for public goods?

Preference regulation Signup and view all the answers

The lemons problem describes a situation characterized by what main issue?

Uncertainty regarding product quality Signup and view all the answers

In game theory, what does the concept of 'sequential rationality' imply?

Choices must be consistent with beliefs at any information set Signup and view all the answers

Which of the following best describes adverse selection?

Low-quality products displace high-quality ones Signup and view all the answers

What is a defining feature of Perfect Bayesian Equilibrium (PBE)?

Best-response strategies must account for updated beliefs Signup and view all the answers

Which problem arises when individuals do not want to reveal their true valuation of a public good?

Preference revelation Signup and view all the answers

Which phenomenon refers to individuals benefitting from a good without contributing to its cost?

The free rider problem Signup and view all the answers

What is a key outcome of moral hazard in insurance?

Diminished incentives for insured individuals to engage in preventative care. Signup and view all the answers

In the context of the principal-agent problem, who is typically the principal?

The insurance company providing coverage. Signup and view all the answers

How can insurance companies limit moral hazard?

By implementing deductibles and cost-sharing measures. Signup and view all the answers

What defines the Bayesian Nash equilibrium?

It includes hypothetical situations not likely to occur in practice. Signup and view all the answers

Why might individuals misperceive their own risk in insurance contexts?

Due to psychological biases or lack of awareness. Signup and view all the answers

Which scenario exemplifies adverse selection in the labor market?

Employees refusing to disclose their true skill level. Signup and view all the answers

What is one method used to help predict risks for policy buyers?

Requiring a physical examination before finalizing life insurance contracts. Signup and view all the answers

What is a potential consequence of ex post moral hazard?

Increased costs associated with recovering from insured events. Signup and view all the answers

What scenario illustrates the concept of asymmetric information?

A seller knowing more about the quality of a car than the buyer. Signup and view all the answers

Study Notes

Week 1

Imperfect and Incomplete Information:
- Asymmetric information: A situation where not all parties to an exchange have the same level of information.
- Sellers often know more: About the quality of a product than buyers.
- Exchange hindered: Asymmetric information can prevent mutually beneficial exchanges for high-quality goods.
- Buyers and sellers adjust: Buyers and sellers might base their decisions on groups or other available information instead of detailed product quality.
- Optimal amount of information: Consumers will continue to gather information until the marginal benefit equals the marginal cost. Beyond that, it is rational to remain uninformed.
- Minimising the risk: Useful information is found when variation in price/quality is high, and the cost of searching for information is low.
- Expected value: The average of the payoffs associated with all outcomes of a decision, weighted by their probabilities.

Attitudes toward risk

Risk Neutral: Constant marginal utility (MU = 1), implying expected value (EV) is equal to utility expectation (EU).
Risk Averse: Diminishing marginal utility (MU < 1), implying expected EV is less than expected EU – Individuals prefer a certain outcome to a risky outcome, and are willing to pay to avoid risk by purchasing insurance.
Risk Loving: Increasing marginal utility (MU > 1), implying expected EU is less than expected EV – Individuals prefer risky outcomes to a certain outcome and engage in risky behaviours (gambling).

Week 2

Risk: Deals with uncertainty about which outcome will occur, described in terms of probability distributions.
Risk Pooling: Pooling together risks across individuals lowers the overall risk compared to individual risks.
Insurance: A promise of payment in case of a particular event, in exchange for a premium.
Consumption Smoothing: Using insurance to transfer consumption from periods of high consumption (low marginal utility) to periods of low consumption (high marginal utility).
Demand for insurance: People seek insurance due to risk aversion – reducing uncertainty and providing security against bad outcomes.

Week 3 & 4

Bayesian Nash Equilibrium: A broader concept of rationality considering hypothetical situations for all possible outcomes.
Adverse Selection: In markets with hidden information, individuals with unfavorable traits have higher incentives to participate in the exchange.
Correlation between riskiness and insurance coverage.
Prevention of adverse selection: Allow insurance companies to predict risk, enabling for adjustments to premiums for more accurate pricing.

Week 5

Externalities: Actions of one party create positive or negative impacts for other parties.
Negative externalities: Occur when a firm's or individual's production/consumption harms others (no compensation).
Positive externalities: Occur when one party's actions provide benefits to others (no compensation).
Private vs Social Welfare: Private welfare considers individuals, while Social welfare aggregates individuals' welfare.

Week 7

Public goods: Goods that are non-rivalrous (consumption by one does not reduce its availability to others) and non-excludable (no one can be prevented from consuming it). Examples are national defence and clean air.
Impure public goods: Satisfy some but not all criteria of public goods - partly rivalrous and partly excludable .
Market provision of public goods: The market does not generate the socially efficient quantity due to the free rider problem.
Free Rider problem: Individuals benefit from the public good but do not contribute their fair share to its provision (lack of incentive for private provisioning).

Week 8

The Lemons Problem: Describes a market where quality is uncertain or unclear. Sellers know more than buyers.
Perfect Bayesian Equilibrium (PBE): A solution concept for sequential games with incomplete information used in game theory.
Sequential rationality: Decisions of market participants are consistent with their beliefs at each stage of the game.

Week 10 & Short Answer Questions

Principal-agent problem: A conflict of interest between a principal who delegates work and an agent who performs the work.
Asymmetric information: The principal cannot observe the agent's behaviour completely.
Information asymmetry creates moral hazard for agents
Optimal provision of public goods: The government can determine the best level of public goods to provide through taxes that lead users to correctly value their worth.
Moral hazard occurs when an individual's behavior changes after a payment is made, creating undesired actions.
Adverse selection Occurs when one party knows more about the quality or risk of the product or service than the other party. This can lead to some high risk consumers overstating or hiding the quality of their need, which leads to decreased product value overall.

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Description

This quiz covers the fundamentals of imperfect and incomplete information in economics, focusing on asymmetric information and its impact on market exchanges. It explores how varying levels of information between buyers and sellers can hinder effective transactions and decision-making processes. Test your understanding of these crucial concepts from week 1.