piu bny thé type of worker you prefer? 14. For each of the following situations,
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piu bny thé type of worker you prefer? 14. For each of the following situations, do the following tirst describe whether it is a situation of moral hazard or of adverse selection. Then explain what inefficiency can arise from this situation and explain how the pro- posed 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 dentists unnecessar- ily for minor complaints, and health maintenance organizations do not know how urgently you need a dentist. A solution is for insurees to have to make a co-payment of a certain dollar amount (for example, $10) each time they visit a health care provider. A insurees are risk-averse. c. When airlines sell tickets, they do not know whether a buyer is a business traveller (who is willing to pay a lot for a seat) or a leisure traveller (who has a low willingness to pay). A solution for a profit maxim that is v and a cheap ticket that is very inflexible (it has to be booked in advance and cannot be changed) izing airline is to offer an expensive ticket ery flexible (it allows date and route changes)Explanation / Answer
1) Adverse selection
Explanation: It is situation of adverse selection because although the seller is aware what type of car she has to sell, but you don’t. If you are not aware of the quality of a car you are offered, then will be willing to pay only the average of what a lemon and a plum are worth to you. Thus the plum sellers are unable to get a price that is high enough for them to want to sell their car, even though if you are aware that you were getting a plum then would be willing to pay enough for them to want to sell it. It is inefficient. With an offer of a warranty, a seller can signal to you that she has a plum: offering a warranty would be very costly for the lemon seller, thus only sellers of plums can afford to offer a warranty. Hence if you notice see a car being offered with a warranty, you know it must be a plum and you are willing to pay high for it.
2) Moral hazard
Explanation: This is a situation of moral hazard because the insurer is not aware whether you are doing the right thing (seeing a doctor only if you are genuinely sick). When the insurance company covered your visit fully, a person might visit his/her physician even for minor headaches, resulting to an excessively high level of claims. The co-payment provides an incentive to visit your physician only when a person is sick enough to be willing to make the co-payment. Inefficiency occurs in the allocation of risk as you are bearing risk (the risk of paying the deductible) that a person would prefer and be willing to pay the insurance company to bear.
3) Adverse selection
Explanation: This is a situation of adverse selection because although the buyer is aware what type of traveler it is (business or leisure), however the airline is unaware. If the airline sold all seats at the same price, it might lose potential earnings from business travelers, and few leisure travelers might decide not to travel at all because of the high. When different tickets are offered, leisure travelers will buy the low-priced inflexible tickets; and business travelers (who require flexibility in their travel plans) will purchase the high-priced flexible tickets.
4) Solution: Moral Hazard
Explanation: This is a situation of moral hazard because the company is unaware on how much effort a worker expends. With a payment of paying piece rates, a worker now has a stake in how much effort workers expends: lower output means less pay, and higher output means more pay. However this is an inefficient allocation of risk. As the worker is risk averse, thus may prefer a certain level of salary for sure, a level that the firm would be willing to pay except for the moral hazard problem. Thus workers are forced to bear high risk than is efficient.
5) Solution: Adverse selection
Explanation: This is a situation of adverse selection because the employers are unaware whether you are a productive employee or unproductive employee. This is inefficient as they will offer a wage that is the average between what productive and unproductive employee should be paid. When a worker is a productive worker than might not be enough to compensate firm and might decide not to work at all. The solution is for productive workers to provide previous employers references. Unproductive workers will be not being able to provide good references, as they will not supply any references at all. Thus having references signals that you are productive employees induces the firm to pay higher salary.
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