quanda22 - Chapter 22 1 For each of the following...

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Practice Questions to accompany Mankiw & Taylor: Economics 1 Chapter 22 1. For each of the following situations, identify the principal and the agent, describe the information asymmetry involved, and explain how moral hazard has been reduced. a. Dental insurance companies offer free annual check-ups Answer: The insurance company is the principal; the insured is the agent. Only the agent knows how well he takes care of his teeth. By checking the insured’s teeth each year, the insurance company can better monitor the behaviour of the insured and reduce major future claims. b. Firms compensate travelling salespersons with commissions (a percentage of the value of the sales) Answer: The firm is the principal; the salesperson is the agent. The firm does not know how hard the salesperson works. By only paying the salesperson a commission, the firm is able to better monitor the salespersons work habits, and the worker is less likely to shirk. c. Agricultural seed companies pay migrant workers bonuses if they work the entire summer season Answer: The firm is the principal; the worker is the agent. The firm does not know how hard the migrant worker works. By paying a large bonus for completing the season, the firm raises the cost of shirking and the cost of being fired. The worker is less likely to shirk. d. McDonald's pays twice the minimum wage to high school students Answer: McDonald’s is the principal; the student is the agent. McDonald’s does not know how hard the student works. By paying above market wages, McDonald’s increases the cost of shirking and the cost of being fired. The worker is less likely to shirk. 2. For each of the following situations, describe the information asymmetry involved, name the type of action that has been taken to reduce adverse selection (signalling or screening), and explain how adverse selection has been reduced. a. McDonald's only hires high school students with good grades Answer: McDonald’s doesn’t know the abilities of the potential workers as well as do the workers. McDonald’s screens potential workers using past educational performance and it is able to select high-ability workers. b. Hyundai (a Korean car manufacturer) provides a 100,000 kilometre warranty on its new cars Answer: Buyers may be unsure of the quality of Hyundai cars because they are relatively new to the European market. Hyundai signals high quality with a long warranty and buyers are able to select high quality cars.
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