Microeconomics Quiz: Information Asymmetry
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Information AsymmetryQuestion 1 of 20

In the market for corporate debt, if lenders cannot easily distinguish between safe and risky firms, a pooling equilibrium may form where all firms are offered loans at an interest rate based on the average risk. What is the most likely long-term consequence of this situation?

Safe firms, finding the interest rate unfairly high, will exit the debt market to seek alternative financing, worsening the risk pool.
The market becomes more efficient as risky firms gain access to capital they otherwise could not secure.
All firms will benefit from the stability of a single market interest rate, leading to greater investment overall.
Lenders will earn higher profits because the interest rate is set high enough to cover losses from the riskiest firms.
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Microeconomics Quiz

Microeconomics Quiz: Information Asymmetry

Practice Information Asymmetry in Microeconomics with focused quiz questions that help you check what you know, review explanations, and build confidence with test-style prompts.

What this quiz covers

This quiz focuses on Information Asymmetry, giving you a quick way to practice the rules, question types, and explanations that matter most for Microeconomics.

How to use this quiz

Try each quiz question before looking at the correct answer. Use the explanations to review missed ideas, then come back to similar questions until the pattern feels familiar.

All questions

Question 1

In the market for corporate debt, if lenders cannot easily distinguish between safe and risky firms, a pooling equilibrium may form where all firms are offered loans at an interest rate based on the average risk. What is the most likely long-term consequence of this situation?

  1. Safe firms, finding the interest rate unfairly high, will exit the debt market to seek alternative financing, worsening the risk pool. (correct answer)
  2. The market becomes more efficient as risky firms gain access to capital they otherwise could not secure.
  3. All firms will benefit from the stability of a single market interest rate, leading to greater investment overall.
  4. Lenders will earn higher profits because the interest rate is set high enough to cover losses from the riskiest firms.
Explanation: This question tests your understanding of adverse selection in credit markets, a key concept in information economics. When lenders face asymmetric information and cannot distinguish between borrower types, pooling equilibria create predictable market dynamics. In this scenario, safe firms know they're low-risk but must pay an interest rate that reflects the average risk of all borrowers. This rate is higher than what they would pay if lenders could properly assess their creditworthiness. Facing this "unfair" pricing, safe firms have strong incentives to find alternative financing sources like retained earnings, equity markets, or private lending arrangements where their true quality can be better recognized. As safe firms exit, the remaining borrower pool becomes increasingly dominated by risky firms, making the original pooling rate inadequate and potentially causing market unraveling. Choice A correctly identifies this adverse selection spiral. Choice B wrongly suggests efficiency gains when the opposite occurs - capital misallocation worsens as information problems persist. Choice C incorrectly assumes all firms benefit from pooling rates, ignoring that safe firms are overcharged relative to their risk. Choice D misunderstands lender profitability - if the pooling rate was set for average risk but safe firms exit, lenders face higher default rates than anticipated, reducing rather than increasing profits. Remember this pattern: whenever you see asymmetric information problems in markets, look for adverse selection effects where high-quality participants exit, leaving behind a deteriorating pool. This dynamic appears across insurance, labor, and credit markets.

Question 2

A firm is concerned about employee shirking (a moral hazard problem). It could try to solve this by paying 'efficiency wages.' How does paying an above-market-equilibrium wage help mitigate moral hazard?

  1. It increases the opportunity cost of being fired for shirking, thus creating a strong incentive for employees to work hard. (correct answer)
  2. It acts as a screening device, ensuring that only the most productive workers apply for the job in the first place.
  3. It signals to competitors that the firm is highly profitable and can afford to pay its workers more.
  4. It directly increases worker productivity by allowing them to afford better nutrition and housing.
Explanation: When you encounter questions about efficiency wages and moral hazard, focus on how economic incentives shape worker behavior. Moral hazard occurs when employees have incentives to shirk because their effort isn't perfectly observable by employers. Efficiency wages solve this by creating a cost to getting fired that exceeds just losing a market-wage job. When a firm pays above-market wages, workers who get caught shirking don't just lose their current income—they lose access to that premium wage and must accept lower-paying alternatives elsewhere. This wage premium creates what economists call an "employment rent"—the extra value workers get from keeping their current job versus their next-best option. The higher this employment rent, the greater the incentive to avoid shirking, making answer A correct. Now let's examine why the other options miss the mark. Answer B confuses efficiency wages with signaling theory—while higher wages might attract better applicants, the primary mechanism for addressing moral hazard is the retention incentive, not the selection effect. Answer C describes signaling to competitors rather than solving the internal shirking problem; this misses the point entirely. Answer D references the "nutrition-based" efficiency wage theory, which applies mainly in developing economies where workers are near subsistence levels—this isn't the standard explanation for how efficiency wages address moral hazard in developed economies. Remember this pattern: efficiency wage questions typically test whether you understand the "cost of job loss" mechanism. The key insight is that above-market wages make getting fired more painful, thereby discouraging the behavior that leads to firing.

Question 3

A homeowner hires a contractor to install a roof, paying $15,000 upfront. The contractor can use high-quality materials (costing $8,000, roof lasts 20 years) or low-quality materials (costing $5,000, roof lasts 8 years). The homeowner discovers material quality only after 5 years when problems may emerge. What contract modification would best address this moral hazard?

  1. Pay the contractor $8,000 upfront and $7,000 after 5 years if no problems occur (correct answer)
  2. Require the contractor to post a $10,000 performance bond refundable after 10 years
  3. Hire an independent inspector to verify material quality before payment
  4. Increase total payment to $18,000 to ensure the contractor uses quality materials
Explanation: This question tests your understanding of moral hazard—when one party (the contractor) has incentives to act against the other party's interests (the homeowner) because their actions can't be easily monitored. The key challenge here is that material quality can't be observed immediately, creating an information asymmetry that the contractor might exploit. The most effective solution is A: splitting the payment so the contractor receives $8,000 upfront and $7,000 after 5 years if no problems occur. This payment structure directly aligns the contractor's incentives with quality work. Since high-quality materials cost $8,000, the upfront payment covers these costs without providing excess profit that might tempt corner-cutting. The deferred $7,000 creates a strong incentive to use quality materials, since problems from cheap materials would likely emerge within the 5-year observation period, costing the contractor this substantial portion of their compensation. B fails because a $10,000 bond refundable after 10 years doesn't adequately incentivize quality—the contractor could use cheap materials, collect the $15,000, and potentially still recover the bond if problems don't manifest until after year 8. C misses the point since material quality verification requires specialized expertise and may not be cost-effective or foolproof. D simply increases the contractor's profit without addressing the underlying incentive problem—more money doesn't automatically ensure quality work. Study tip: When analyzing moral hazard problems, look for solutions that create financial consequences tied directly to the undesirable behavior's timeline. The best contracts make it costly for the agent to act against the principal's interests.

Question 4

A health insurance company observes that policyholders with comprehensive coverage visit doctors 40% more frequently than those with basic coverage, even for minor ailments. The company also notices that individuals who purchase comprehensive coverage have 20% higher baseline health risks than those choosing basic coverage. What explains the difference in doctor visit frequency?

  1. Entirely adverse selection, as sicker people buy comprehensive coverage and need more care
  2. Entirely moral hazard, as comprehensive coverage reduces the marginal cost of doctor visits
  3. Combination of adverse selection (20% effect) and moral hazard (remaining 20% effect) (correct answer)
  4. Neither adverse selection nor moral hazard, but rather income effects from insurance wealth
Explanation: The 20% higher baseline risk explains part of the increased usage through adverse selection (sicker people self-selecting comprehensive coverage). However, since visit frequency increases 40% while risk differences are only 20%, the additional 20% represents moral hazard - behavioral changes due to reduced out-of-pocket costs making medical care effectively cheaper for comprehensive coverage holders.

Question 5

A bank offers two loan contracts: Contract A requires a $500 application fee but offers a 5% interest rate, while Contract B has no application fee but charges 8% interest. If only high-quality borrowers (default risk 2%) find it profitable to pay the application fee, while all borrowers accept Contract B, what type of asymmetric information problem does this represent?

  1. Moral hazard, because borrowers change their behavior after receiving loans
  2. Adverse selection, because the contracts reveal private information about borrower quality (correct answer)
  3. Signaling equilibrium, where low-quality borrowers mimic high-quality borrowers through fee payment
  4. Screening failure, because the bank cannot distinguish between borrower types
Explanation: This is adverse selection with screening. The bank designs contracts to separate borrower types based on their private information about default risk. High-quality borrowers self-select into Contract A because the fee is worthwhile given the lower interest rate, while low-quality borrowers choose Contract B. The contracts reveal (don't create) existing private information.

Question 6

A delivery company pays drivers $20 per hour for an 8-hour shift regardless of deliveries completed. The company cannot monitor effort directly, and drivers can choose high effort (completing 40 deliveries, personal cost $50) or low effort (completing 25 deliveries, personal cost $20). If the company switches to paying $4 per delivery with no base wage, what is the primary information asymmetry concern?

  1. Adverse selection, because only highly skilled drivers will apply for jobs
  2. Moral hazard, because drivers may sacrifice delivery quality for quantity (correct answer)
  3. Signaling, because productive drivers will work longer hours to demonstrate ability
  4. Screening failure, because the company cannot identify driver productivity before hiring
Explanation: This is moral hazard because the payment change affects post-contract behavior. Under per-delivery payment, drivers have incentives to maximize deliveries, potentially rushing and reducing quality, driving recklessly, or cutting corners. The information asymmetry is about unobservable actions (effort allocation between speed and quality) after the contract is signed.

Question 7

An online marketplace allows sellers to offer products with hidden quality levels. High-quality sellers (cost $40, value to buyers $80) can obtain third-party certification for $15, while low-quality sellers (cost $20, value to buyers $35) face certification costs of $25. If buyers cannot distinguish quality without certification and there are equal numbers of each seller type, what market outcome occurs?

  1. All sellers obtain certification, and buyers pay $57.50 for certified products
  2. No sellers obtain certification, and buyers pay $57.50 for uncertified products
  3. Only high-quality sellers certify, creating separate markets with different prices (correct answer)
  4. Low-quality sellers exit the market, leaving only certified high-quality sellers
Explanation: High-quality sellers benefit from certification: they can charge $80 instead of pooled price $57.50, gaining $22.50 > $15 cost. Low-quality sellers lose from certification: they'd pay $25 to charge $35 instead of $57.50, losing $47.50. This creates separating equilibrium: certified products sell for $80, uncertified for $35, with buyers knowing uncertified means low quality.

Question 8

A venture capital firm evaluates startup proposals where entrepreneurs privately know their project quality. High-quality projects (success probability 0.7, return $10M) require $2M investment, while low-quality projects (success probability 0.3, return $10M) require $1.5M investment. If entrepreneurs can credibly burn $600K in pre-revenue marketing, what signaling equilibrium emerges when the VC offers identical terms to all entrepreneurs?

  1. Both entrepreneur types engage in marketing spending, eliminating the signal's value
  2. Low-quality entrepreneurs spend more on marketing to appear high-quality
  3. No entrepreneurs spend on marketing, and the VC pools all projects together
  4. Only high-quality entrepreneurs spend on marketing, revealing their type to investors (correct answer)
Explanation: When you encounter signaling problems in microeconomics, focus on whether the signaling cost differs between types and whether separation is profitable. Signaling works when high-quality types find it relatively cheaper to send the signal than low-quality types. Let's analyze the payoffs. High-quality entrepreneurs have expected returns of 0.7×$10M−$2M=$5M0.7 \times \$10M - \$2M = \$5M without signaling. If they spend $600K on marketing and successfully signal their quality, they still earn $\5M - $0.6M = $4.4M . This signaling cost represents only 12% of their expected profit. Low-quality entrepreneurs have expected returns of 0.3 \times $10M - $1.5M = $1.5M without signaling. The $600K marketing cost would consume 40% of their expected profit, leaving only $900K. This makes signaling prohibitively expensive for low-quality types. Since high-quality entrepreneurs can profitably signal while low-quality entrepreneurs cannot, a separating equilibrium emerges where only high-quality entrepreneurs engage in marketing, making D correct. Option A is wrong because the signal retains value when only one type uses it. Option B incorrectly suggests low-quality entrepreneurs would spend more when the fixed $600K cost is actually too high for them relative to their profits. Option C fails because high-quality entrepreneurs benefit from signaling their superior type rather than being pooled with low-quality projects. Remember: successful signaling requires the cost to burden low-quality types more than high-quality types. Always compare the signaling cost as a percentage of each type's expected profits to determine who will signal.

Question 9

A used car dealer knows that 40% of the cars on his lot have hidden mechanical problems, while buyers cannot distinguish between good and problematic cars before purchase. If buyers are risk-neutral and value good cars at $15,000 and problematic cars at $6,000, what is the maximum price buyers would be willing to pay, and what market outcome is most likely to occur?

  1. Buyers will pay up to $11,400, and only sellers of problematic cars will participate, leading to market collapse (correct answer)
  2. Buyers will pay up to $11,400, and both types of sellers will participate in equilibrium
  3. Buyers will pay up to $9,000, and sellers will separate by offering warranties on good cars
  4. Buyers will pay up to $9,000, and the market will clear with both car types being sold
Explanation: Buyers' willingness to pay equals expected value: 0.6(15,000)+0.4(15,000) + 0.4(6,000) = $11,400. However, at this price, owners of good cars (worth $15,000) won't sell, so only problematic cars enter the market. Recognizing this adverse selection, rational buyers won't pay $11,400 for cars they know are problematic, leading to market unraveling.

Question 10

In a market for professional services, high-ability consultants (marginal cost $100/hour, productivity worth $200/hour to clients) can obtain MBA degrees at cost $50,000, while low-ability consultants (marginal cost $100/hour, productivity worth $120/hour) face MBA costs of $80,000. If clients cannot observe ability but pay based on expected productivity, what signaling equilibrium will emerge?

  1. Both types obtain MBAs, and signaling fails to separate consultant types effectively
  2. Neither type obtains MBAs, and the market operates with pooling at average productivity
  3. Only high-ability consultants obtain MBAs, creating a separating equilibrium (correct answer)
  4. Low-ability consultants obtain MBAs to mimic high-ability consultants
Explanation: For signaling to work, high-ability consultants must find it profitable while low-ability consultants don't. High-ability benefit: ($200-$120)×hours worked > $50,000. Low-ability loss: benefit of $0 (no productivity increase) < $80,000 cost. Since high-ability consultants have lower signaling costs and higher returns, only they will obtain MBAs, creating separation.

Question 11

A country's individual health insurance market is experiencing a 'death spiral' due to adverse selection. Insurers cannot distinguish between high-risk and low-risk individuals, causing premiums based on average risk to be too high for low-risk individuals, who then exit the market. Which government intervention most directly addresses the root cause of this specific market failure?

  1. Imposing a price ceiling on insurance premiums to ensure they remain affordable for all consumers.
  2. Providing a government subsidy for insurance premiums paid by all individuals, regardless of their income.
  3. Mandating that all individuals must purchase a qualifying health insurance plan or pay a penalty. (correct answer)
  4. Funding a public awareness campaign to encourage healthy lifestyles and reduce the population's overall risk level.
Explanation: The root cause of the adverse selection death spiral is that low-risk individuals can opt out of the market. A mandate (C) solves this by forcing everyone, including the healthy, into the insurance pool. This creates a balanced risk profile, allowing insurers to set premiums based on the true average risk of the entire population. (A) would likely worsen the problem by forcing insurers to sell at a loss, leading to market exit. (B) helps with affordability but doesn't stop low-risk individuals from leaving if the premium is still a bad deal for them. (D) is a long-term health policy but does not fix the immediate information and selection problem.

Question 12

According to the signaling theory of education, a college degree conveys information about a worker's innate ability rather than providing useful job skills. If this theory is entirely correct, which of the following outcomes would be inconsistent with the theory?

  1. Most college graduates report that the specific subject matter they studied is not directly applicable to their daily job tasks.
  2. A university makes its curriculum significantly easier for everyone to pass, and subsequently, the average wage of its graduates falls.
  3. A company starts a highly effective in-house training program for non-college graduates, who then become more productive than its college-educated employees. (correct answer)
  4. Employers offer higher salaries to graduates from more selective universities, even for identical roles and responsibilities.
Explanation: The signaling model posits that firms pay higher wages to college graduates because the degree is a credible signal of high innate ability. If a company finds that non-graduates, after training, are more productive (C), it implies that actual skills (human capital), not just the signal, are what drive productivity. This observation would contradict the pure signaling theory, suggesting that firms are misinterpreting the signal and could be more profitable by hiring and training non-graduates. (A), (B), and (D) are all consistent with the signaling model: course content doesn't matter (A), a less costly/credible signal is less valuable (B), and a more costly/credible signal is more valuable (D).

Question 13

A firm that sells high-end electronics offers an optional extended warranty for an additional fee. The firm observes that the frequency of claims and average repair costs are significantly higher for customers who purchase the warranty than for those who do not. This phenomenon can be explained by:

  1. Adverse selection only, as customers who know they are clumsy or use their devices in high-risk environments are more likely to buy the warranty.
  2. Moral hazard only, as customers become less careful with their devices after purchasing the warranty, knowing they are covered against damage.
  3. Both adverse selection and moral hazard, as high-risk users are more likely to buy the warranty, and all buyers may be less careful post-purchase. (correct answer)
  4. A signaling failure, where the high price of the warranty incorrectly signals that the underlying product is unreliable and prone to breaking.
Explanation: This is a classic case where both problems are likely present. Adverse selection occurs before the purchase: individuals who anticipate a higher need for repairs (e.g., they are clumsy, have children, use the device for rugged work) will self-select into buying the warranty. Moral hazard occurs after the purchase: having the warranty may cause an individual to be less careful than they would have been otherwise (e.g., not using a protective case). Since both effects contribute to the higher claim rate, (C) is the most complete and accurate explanation.

Question 14

A property owner hires a manager to run an apartment complex. To align incentives, the owner pays the manager a large bonus based on achieving a 98% occupancy rate. The manager achieves this target, but does so by reducing rental standards and leasing to tenants who are frequently late with payments and cause property damage. This outcome demonstrates that:

  1. the bonus system successfully resolved the principal-agent problem by focusing the manager on a key performance metric.
  2. adverse selection was the true problem, as the owner should have screened for a more scrupulous manager.
  3. the incentive scheme, while mitigating one form of moral hazard (low effort), created another by encouraging costly, unobservable actions. (correct answer)
  4. a higher occupancy rate target, such as 100%, would have forced the manager to find only high-quality tenants.
Explanation: This is a multi-step moral hazard problem. The bonus based on occupancy was designed to solve one potential issue (the manager not working hard to find tenants). However, it created a new moral hazard problem. The agent (manager) took actions (lowering standards) that were not easily observable by the principal (owner) to maximize their own pay, even though these actions harmed the principal's long-term profitability. (A) is incorrect as the problem was not resolved. (B) is less accurate because the issue is the manager's response to the incentive scheme, which is a moral hazard issue. (D) would likely make the problem worse, increasing the incentive to cut corners.

Question 15

Consider the market for used cars, where there are high-quality cars ('cherries') and low-quality cars ('lemons'). Sellers know their car's quality, but buyers do not. Sellers of cherries have a reservation price of $10,000. Sellers of lemons have a reservation price of $4,000. Buyers are willing to pay $12,000 for a cherry and $6,000 for a lemon. If buyers believe there is a 50% chance of getting either type of car, which of the following will occur?

  1. Buyers will offer up to $9,000, and both cherries and lemons will be sold in the market.
  2. Buyers will offer up to $9,000, but only sellers of lemons will accept, leading to market failure. (correct answer)
  3. Buyers will offer up to $8,000, the average reservation price, causing all sellers to exit the market.
  4. The market will be efficient because the buyers' maximum price is higher than the sellers' average reservation price.
Explanation: A risk-neutral buyer's expected value is (0.5 * $12,000) + (0.5 * $6,000) = $6,000 + $3,000 = $9,000. So, the maximum price a buyer will offer is $9,000. At this price, sellers of lemons (reservation price $4,000) are happy to sell. However, sellers of cherries (reservation price $10,000) will not sell for $9,000. Therefore, only lemons will be offered for sale. This is Akerlof's 'Market for Lemons,' where adverse selection drives high-quality goods out of the market.

Question 16

A government agency pays a private contractor to maintain a public highway. The contract specifies payments based on the number of potholes repaired per month. To maximize profit, the contractor uses a cheap, low-quality asphalt that quickly deteriorates, ensuring a steady stream of new potholes to repair in subsequent months. This behavior is a direct result of:

  1. adverse selection, where only low-quality contractors bid for government projects.
  2. a negative externality imposed on the driving public.
  3. moral hazard, stemming from an incentive structure that rewards an easily measured output instead of the desired outcome. (correct answer)
  4. a lack of competition in the market for highway maintenance contractors.
Explanation: This is a moral hazard problem. The principal (government) wants a well-maintained road (the outcome), but the contract pays the agent (contractor) based on a proxy for effort (number of repairs). The agent's action (using low-quality materials) is not easily monitored by the principal. The contractor takes this hidden action to maximize its payments at the expense of the principal's objective. (A) is about who gets the contract, not the behavior after signing it. (B) is a consequence, but the root cause is the information problem in the contract. (D) might be true, but the direct cause of this specific behavior is the flawed incentive scheme.

Question 17

A firm needs to hire a worker for a remote task where individual effort determines output, but effort itself is impossible to monitor. Which compensation scheme would be most effective in overcoming the moral hazard problem inherent in this situation?

  1. A high, fixed weekly salary combined with the threat of termination for unsatisfactory performance.
  2. Paying the worker an hourly wage based on the number of hours they self-report.
  3. A piece-rate system where the worker is paid a set amount for each unit of output produced. (correct answer)
  4. A profit-sharing plan where the worker receives a small percentage of the firm's overall quarterly profits.
Explanation: The most direct way to solve the moral hazard problem of shirking is to link pay directly to output. A piece-rate system (C) does this perfectly. The worker's incentive (to produce more to earn more) is aligned with the firm's goal (to get more output). (A) is an efficiency wage, but relies on monitoring to detect poor performance, which the stem says is impossible. (B) simply creates a new moral hazard problem of misreporting hours. (D) is too indirect; the worker's individual effort has a negligible impact on the overall firm's profits, so the incentive effect is very weak.

Question 18

A venture capitalist (VC) invests in a high-tech startup. The entrepreneur, who runs the company, has more information about the project's daily progress and challenges than the VC. The VC is concerned the entrepreneur might not work as hard once the funding is secured. To mitigate this problem, the VC's investment contract is likely to include which of the following features?

  1. The funding is provided in stages (tranches), with each new tranche of funding conditional on the startup meeting specific, pre-agreed milestones. (correct answer)
  2. A requirement that the startup provides the VC with a fixed-rate interest payment each year, regardless of performance.
  3. The entrepreneur must sign a non-disclosure agreement to prevent them from sharing proprietary information with competitors.
  4. A clause giving the VC the right to purchase the entire company at a pre-determined price at any time.
Explanation: This question tests your understanding of moral hazard in principal-agent relationships. When one party (the agent) has more information or control than the other (the principal), the agent might behave differently once they've secured benefits, potentially acting against the principal's interests. Here, the VC (principal) faces moral hazard because the entrepreneur (agent) has better information about daily operations and might reduce effort once funding is secured. The VC needs a mechanism to maintain entrepreneur incentives throughout the project. Answer A is correct because staged funding with milestone-based releases directly addresses moral hazard. By conditioning each funding tranche on meeting specific performance targets, the VC ensures the entrepreneur maintains high effort levels to secure continued financing. This creates ongoing accountability and aligns incentives between both parties. Answer B is wrong because fixed interest payments don't solve the moral hazard problem—they're just a financing arrangement that doesn't tie entrepreneur compensation or continued funding to performance. The entrepreneur could still slack off while making required payments. Answer C is wrong because non-disclosure agreements address information leakage to competitors, not the moral hazard of reduced entrepreneur effort. This solves a different problem entirely. Answer D is wrong because a buyout option gives the VC an exit strategy but doesn't create ongoing incentives for entrepreneur effort. It's more about control rights than performance motivation. Study tip: When you see principal-agent problems with moral hazard, look for solutions that tie ongoing benefits to continued performance—not one-time payments or unrelated contractual provisions.

Question 19

An insurance company offers health insurance to a population where 30% are high-risk individuals (expected annual medical costs of $8,000) and 70% are low-risk individuals (expected annual medical costs of $2,000). If the company sets premiums based on average risk and high-risk individuals are twice as likely to purchase insurance as low-risk individuals, what will be the company's expected loss per policy sold?

  1. The company will break even with zero expected loss per policy
  2. The company will lose approximately $960 per policy sold (correct answer)
  3. The company will lose approximately $1,200 per policy sold
  4. The company will profit approximately $400 per policy sold
Explanation: Average population cost: 0.3(8,000)+0.7(8,000) + 0.7(2,000) = $3,800, so premium = 3,800.Amongpurchasers:high−riskproportion=(0.3×2)/(0.3×2+0.7×1)=0.6/1.3≈0.46;low−riskproportion≈0.54.Expectedcostperpolicy:0.46(3,800. Among purchasers: high-risk proportion = (0.3×2)/(0.3×2 + 0.7×1) = 0.6/1.3 ≈ 0.46; low-risk proportion ≈ 0.54. Expected cost per policy: 0.46(8,000) + 0.54($2,000) = $3,680 + $1,080 = $4,760. Loss per policy: $4,760 - $3,800 = $960.

Question 20

Government-backed deposit insurance, which protects depositors' funds if a bank fails, was implemented to prevent bank runs. However, it can also create moral hazard by altering the bank's incentives. Which of the following best exemplifies this moral hazard?

  1. A bank carefully screens all loan applicants and maintains a diversified portfolio of loans to minimize default risk.
  2. A bank uses the safety provided by deposit insurance as a key marketing point in its advertisements to attract new customers.
  3. Depositors, feeling secure, no longer feel the need to monitor their bank's financial health or investment strategies.
  4. A bank's management makes riskier loans and investments than it otherwise would, knowing that depositors are protected from losses. (correct answer)
Explanation: The moral hazard from deposit insurance arises on the bank's side. Because depositors are insured, they won't withdraw their funds even if the bank takes on excessive risk. This frees the bank (the agent) to pursue high-risk, high-return strategies that can benefit its shareholders if they pay off, while the government insurance fund (and ultimately, taxpayers) bears much of the loss if they fail. (A) is prudent banking, the opposite of moral hazard. (B) is a marketing strategy. (C) describes moral hazard on the part of the depositor, which is a real phenomenon, but the primary concern of regulators is the change in the bank's risk-taking behavior, which has larger systemic consequences.