Practice problem set 6

Managerial Economics
PGP – 1: Term 1, Section A, 2019-2020

1) John is a 55-year-old male smoker, about 50 pounds overweight, who has high
blood sugar and drinks to excess a couple of times each month. Because of adverse
selection in health insurance,
A) John is less likely to buy health insurance than the average person, because the
average person's policy premiums will be based on his risk, not the average risk.
B) John is more likely to buy health insurance than the average person, because his
policy premiums will be based on the average risk, not his personal risk.
C) when John gets health insurance, he will be less likely to take care of himself.
D) when John gets health insurance, he will be more likely to take care of himself.
E) if John doesn't have health insurance already, he will not be able to get it.

2) Consider a market in which high-quality and low-quality television sets are sold.
Before consumers make a purchase, they do not know the quality of the sets, but the
sellers do know. As compared to a situation where both consumers and sellers know
the quality of the sets, this situation would
A) cause no change in the ratio of low to high-quality sets sold.
B) increase the fraction of high-quality sets sold.
C) increase the fraction of low-quality sets sold.
D) cause the average price of goods sold to rise.

3) If grades are to be a successful signal to potential employers of a student's qualities,

then higher grades must be
A) easier for high-productivity students to earn than for low-productivity students to
earn.
B) easier for low-productivity students to earn than for high-productivity students to
earn.
C) easy for employers to check.
D) used for all future promotions within the firm.
E) often referred to in the hiring process.

4) The process by which sellers send signals to buyers conveying information about
product quality is known as:
A) asymmetric information.
B) market signaling.
C) a lemons problem.
D) moral hazard.

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5) Job market signals like dressing well for interviews are not especially effective
because:
A) the cost of dressing well is about the same for high-quality and low-quality
workers.
B) many businesses have adopted casual office attire, so dressing well is not important
to the firm.
C) federal labor laws prohibit firms from using dress or appearance as an employment
criterion.
D) none of the above

Scenario 17.3
Consider the following information:

The probability of a fire in a factory without a fire prevention program is 0.01. The
probability of a fire in a factory with a fire protection program is 0.001. If a fire
occurred, the value of the loss would be $300,000. A fire prevention program would
cost $80 to run.

6) Refer to Scenario 17.3. If there is no insurance and a fire protection program in

place, the expected loss from fire for this company is
A) $0.
B) $300.
C) $3,000.
D) $6,000.
E) $300,000.

7) Refer to Scenario 17.3. If there is no insurance and no fire protection program in

place, the expected loss from fire for this company is
A) $0.
B) $300.
C) $3,000.
D) $6,000.
E) $300,000.

8) Refer to Scenario 17.3. If the fire protection program were in place, the company
could insure the warehouse for a premium equal to
A) the loss from the fire, $300,000.
B) the expected loss from the fire, $300.
C) the expected loss from the fire, $3,000.
D) the cost of the fire protection program, $80.
E) $0.

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9) Refer to Scenario 17.3. If the fire protection program were not in place, the insurer
would not be willing to ensure the warehouse for any amount less than
A) $80.
B) $300.
C) $3,000.
D) $6,000.
E) $300,000.

10) Refer to Scenario 17.3. Moral hazard arises in this situation because once the firm
A) pays the premium that is based on the 0.001 probability, it has no incentive to spend
the additional $80 for the fire protection program, so the true probability of loss is no
longer 0.001.
B) pays the premium that is based on the 0.01 probability, it has no incentive to spend
the additional $80 for the fire protection program, so the true probability of loss is no
longer 0.01.
C) puts the fire protection program in place, it has less incentive to spend $300 for a
premium, leaving the firm underinsured.
D) puts the fire protection program in place, it has less incentive to spend $6,000 for a
premium, leaving the firm underinsured.
E) puts the fire protection program in place, it will consider that a substitute for
insurance and not be able to deal with the loss from a fire should it occur.

11) Refer to Scenario 17.3. Moral hazard would be eliminated in this situation if
A) the insurer would always charge $300.
B) the insurer would always charge $6000.
C) the insurer could costlessly monitor whether a fire prevention program has been
implemented, and adjust the premium upward if it is not.
D) the insurer could costlessly monitor whether a fire prevention program has been
implemented, and adjust the premium downward if it is not.
E) the fire did not occur.

Scenario 17.5
Consider the following information:

Income to the firm from workers who sell door-to-door

Bad Luck Good Luck

Low Effort (e = 0) $5,000 $7,000
High Effort (e = 1) $7,000 $13,000

Cost of effort: c = $2500e

Probabilities: Bad luck = .75; Good luck = .25

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12) Refer to Scenario 17.5. If low effort is exerted, expected income is
A) $5000.
B) $5500.
C) $6000.
D) $6500.
E) $7000.

13) Refer to Scenario 17.5. If a fixed wage of $3000 is given the individual worker, the
result will be
A) low effort 75% of the time.
B) low effort 25% of the time.
C) low effort.
D) high effort.
E) high or low effort depending on whether the worker thinks the $3000 is an
acceptable wage.

14) Refer to Scenario 17.5. The owners can't know whether the workers are exerting
high or low effort if income is
A) $5000.
B) $7000.
C) above $7000.
D) $13,000.
E) above $13,000.

15) Refer to Scenario 17.5. Under which of the following payment schemes would
workers have an incentive to exert high effort?
A) A guaranteed wage equal to $0
B) A guaranteed wage equal to $5000
C) A guaranteed wage equal to $10,000
D) A wage equal to the income earned, minus $4000
E) A wage equal to $0 if revenue is $5000, $2000 if revenue is $7000, and $8000 if
revenue is $13,000

16) The efficiency wage is

A) lower than the market-clearing wage, to penalize shirking.
B) higher than the market-clearing wage, to penalize shirking.
C) lower than the market-clearing wage, to allow managers the resources to monitor
shirking.
D) higher than the market-clearing wage, to reward workers for informing on others
who shirk.
E) lower than the market-clearing wage, because of shirking done by managers.

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17) Suppose new electronic devices make it easier to monitor the effort levels of
workers. If some shirking is still possible in the efficiency wage model, what happens
to the efficiency wage?
A) Declines, but remains above the market-clearing wage
B) Declines, and falls below the market-clearing wage
C) Increases
D) Does not change

18) Loud music from a neighbor's party is

A) a negative externality whether or not you like it.
B) a positive externality whether or not you like it.
C) a positive externality if you like the music, and a negative externality if you don't.
D) a negative externality if you like the music, and a positive externality if you don't.
E) not an externality.

19) Common property resources tend to be

A) overused.
B) underused.
C) not used at all.
D) efficiently used.
E) used by the government only.

20) The government provides public education because

A) public education is a public good.
B) public education is non-rival and nonexclusive.
C) private education is rival and exclusive.
D) public education combats the negative externalities of private education.
E) public education provides positive externalities.

21) A consumer or producer who does not pay for use of a nonexclusive good but
expects others to pay is known as a:
A) free rider.
B) price setter.
C) fringe element.
D) none of the above

22) What type of good is clean air?

A) Rival and exclusive
B) Nonrival and exclusive
C) Rival and nonexclusive
D) Nonrival and nonexclusive

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Short answer questions

23) As part of the most recent collective bargaining agreement with state employees, a state
government must offer dental insurance at "reasonable, nonprofit rates." The state plans to
self insure in place of using a private insurance company. Statistical evidence suggests that
the average household currently spends $300 per year for corrective dental work and $80 for
routine checkups. Administrative costs are expected to average $20 per family. The
collective bargaining agreement dictates that the plan's coverages and rates be fixed for a
period of three years. The auditor considers the choice of the plan to be extremely important.
Consequently, the auditor has asked you to evaluate the three proposals listed below in terms
of their propensity to result in adverse selection and/or moral hazard. Proposal 1 would
charge a $400 premium with no deductible (the amount paid out of pocket by the policy
holder). Coverage is extended to preexisting conditions, but to cover the nondeductible
clause, routine checkups are not covered. Proposal 2 charges a $200 premium with a $200
deductible. The plan does not cover preexisting conditions, but does cover routine office
visits. Proposal 3 charges a $150 premium with a $150 deductible. This plan doesn't cover
preexisting conditions or routine checkups. The collective bargaining agreement dictates that
participation in the plan must be at the employee's option.

24) In this problem, a labor market exists where employers hire and pay workers according to
how much formal education workers possess. Education is a proxy for the level of
productivity that employers can expect from workers. Therefore, employers follow a strategy
in which they hire workers and pay salaries according to the following conditions:

Degrees Above the Values of Post High School

High School Level Education During Working Life, B(y)
None 0
(y = 0 years)
Associate's Degree $30,000
(y = 2 years)
Bachelor's Degree $51,000
(y = 4 years)
Master's Degree $58,000
(y = 6 years)

Assume that there are only two types of worker abilities, those who are less productive (type
L) and those who are highly productive (type H). The less productive workers have to study
harder than highly productive workers in order to earn any degree. Consequently, the costs
(including the psychic costs of study effort) of attaining various levels of education for these
two types of employees are different.
For less productive workers: CL(y) = $13,000y
For highly productive workers: CH(y) = $10,000y

a. Draw a diagram with years of education on the horizontal axis. Graph the benefits to
education B(y) and the costs of education for each of the two types of workers. Discuss what
level of education each type of worker should obtain.
b. Now use the equations above to verify your answer from part (a) mathematically.
c. Explain the value of formal education above the high school level in the market place to
employers.

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25) Assume that the owners of a firm know that the firm's profits will depend upon two
parameters: (1) how hard the managers work, and (2) the state of the economy. For
simplicity, assume that the managers can exert either maximum or minimum effort and that
the economy can be either favorable or unfavorable with equal probabilities. The profits
under various situations are represented by the matrix below.

Favorable Unfavorable
Economy Economy
Maximum Effort 700,000 400,000
Minimum Effort 400,000 200,000

The firm considers there to be an equal probability of either state of the economy. The
manager considers the cost of effort to be C = 55,000x, where x = 1 for maximum effort, 0
for minimum effort. The firm is considering the pay scheme described below. Evaluate each
alternative in terms of their incentive effects for the manager and their effect on the firm's
profitability.

a. a flat salary of $30,000 that is not tied to the firm's performance

b. a bonus of 0 if profit equals 200,000 or 400,000 and a bonus of 120,000 if profit equals
700,000
c. a bonus determined by the formula: B = 0.20(PROFIT - 300,000)
d. a bonus determined by the formula: B = 0.24(PROFIT - 300,000)