Solution

ECO204: Solutions to Homework 5 1. True, False, Uncertain a. False. Methods to eliminating moral hazard include writing efficient contracts between principals and agents, bonding and deferred payments. The methods to eliminate adverse selection include sending signals and relying on 3rd parties to verify quality. b. True. When there is asymmetric information, it drives out high-quality goods because consumers have a difficult time differentiating between high- and low-quality goods. As a result, they are only willing to make an offer equal to the expected value, which is lower than the value of the high-quality good. This drives out sellers of high-quality goods, so that only low quality goods are sold. When there are only low quality goods in the market, the price that is offered (the EV) is higher than the value of the product or its marginal cost (allowing sellers of low-quality goods to make a profit). c. False. Principals will write contracts for their agents to prevent moral hazard, not adverse selection. d. False. For contracts to be efficient, they must not only discourage moral hazard (the opportunity to lie/cheat the principal), but also encourage efficiency in production (the agent should produce the optimal units of output that max profits) and allocate risk efficiently (the risk-averse individual bears less risk than the risk-neutral individual). e. Uncertain – it depends on the contract. According to the summary table on contracts we filled out (I’ve posted this on Blackboard) there are instances where the individual was originally not efficiently producing goods under perfect information, but later changed their behavior with asymmetric information because there was an opportunity to underreport his/her effort level and profit from the sale of unreported goods (Cases 2a and 3a). For these two cases, the statement is false. Since the sale price of unreported goods is dependent on the equilibrium market price, the worker will switch from being