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Economics
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2 Feb 2018

A colleague tells you that he can get a business loan from the bank, but the rates seem very high for what your colleague considers a low risk loan.

• Give an adverse selection explanation for this, and offer advice to your friend on how to solve the problem.

•Give a moral hazard explanation for this, and offer advice to your friend on how to solve the problem.

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Sixta Kovacek
Sixta KovacekLv2
4 Feb 2018
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Related questions

  1. Are the following examples of Adverse Selection or of Moral Hazard?

    1. An employee who has a long-term contract with a firm stops working as hard as he

      might have otherwise.

    2. People with good health insurance make more visits to the doctor for very minor

      health problems.

    3. . A mechanic performs needless repairs on a car to increase his profit. e. Healthy people decline to purchase health insuranc

    4. Healthy people decline to purchase health insurance

    5. The people most likely to sign up for a dating service are losers.

    6. Your cousin gets you to invest in his new dog-walking business, but then he just lies

      on the couch all day watching DVDs.

1) Insurance and social policy

You are making an app with a 5% chance of making a ton-load of money, and 95% chance of earning nothing. Your utility is the square root of income (Utility = Y1/2); you will have $10,000,0001/2 happiness if your app succeeds but 01/2 happiness if it fails.

a) (2 points) What is the expected value of your app? How much money can you expect to make? What is your utility at that income (if you know that your income will be the expected value of your app)?

Note that in EXCEL, the square root function is “=X^.5” for the number X

b) (1 point) What is your expected utility from your app? (Note: this is the weighted average of utility when the app succeeds and when it fails where the weight is the probability of success.)

c) (2 points) Why do people buy insurance? How can insurance companies profit? What happens to expected utility when people can buy insurance at a fair market price?

d) (2 points) What is moral hazard and what is adverse selection. How do these affect insurance markets? Give examples from the marketing of veterinary insurance. Would you expect markets with moral hazard and adverse selection to provide the optimal amount of veterinary insurance at an efficient price?

2.1 Adam Smith is often called the father of economics. His famous book, The Wealth of Nations, talks about an invisible hand which automatically allocates goods to the persons most able to put them to good use. The invisible hand operates through the price mechanism for goods and services, so that individuals who trade on the market, while seeking only their own good, are actually efficiently allocating society's resources.

His ideas, if applied to modern capital markets, imply that these markets would efficiently allocate investment capital to the firms that would use the capital most efficiently in producing goods and services for society. But this would happen only if markets were left to operate without state intervention.

Do you think modern governments should leave capital markets unregulated? Why or why not?

2.2 Consider a business firm, organized as a proprietorship, which has $100,000 invested in assets a bank loan of $80,000 and $20,000 personal capital invested by the proprietor. If the firm becomes insolvent, who is at risk? Why?

2.3 In the following situation, moral hazard or adverse selection may be present. Indicate which you think is present, if any, and explain your choice.

a. An investor is asking for a bank loan to support a new business she wants to operate. She is unwilling to submit to a credit check.

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