Econ 3003- Money and Banking Problem Set 2.1

Professionalism means

. typed because it is easy to read.

. you should show your calculations because your reader might need to understand how you got your answer in order to (1) make sure it is correct and (2) understand how to interpret your answer.

. proofread because spelling and grammar mistakes (1) distract from your point, and reduce your credibility as an educated, intellectual person of authority.

. equations are typed using an equation editor because it is very difficult to read in‐line equations when fractions are compressed into one line.

. explaining your answer because sometimes the answer itself is not important, rather the explanation is the important part.

1. Classify each of the following as examples of Moral Hazard, Adverse Selection or Neither. Explain your answer and note one way to alleviate the problem.

a) A board of directors oversees the operations of a company and its management.

b) Stock holders may not get the optimal amount of dividends because profits are reinvested in the company in order to maximize the CEO’s influence.

c) The principle‐agent problem

d) The lemons problem

e) Some people claim that: A free democracy in Iraq could encourage emmigration of freedom seeking Iranian students from Iran to Iraq thus reducing the pressure on the Iranian government to reform.

f) Some people claim that: A functioning democracy in Iraq will cause the Iranian government to tighten restrictions on its population, making democracy in Iran less likely to occur peacefully.

g) A depressed individual might buy life insurance before committing suicide.

2. Is the lemons problem more severe for bonds issued by democratic governments or dictatorships? Explain.

3. Which of the following are attempts to solve an asymmetric information problem? Explain.

a) Auditing firms (hired by the board of directors and approved by the shareholders)

b) Stock broker’s commissions

c) Private Production and sale of information

d) Financial intermediation

e) Collateral

4. Rich people often worry that others will seek to marry them only for their money. Is this a problem of adverse selection? Explain.

Moral Hazard and Adverse Selection Problems

1.

a.) Neither. It cannot be classified as a moral hazard or an adverse selection problem.

b.) Neither. This is because it is a statement of the principle-agent problem.

c.) It is a Moral Hazard problem that can be remedied by government regulations, auditing or selecting a Board of Directors to monitor the activities of the management.

d.) It is an adverse selection that can be remedied by collecting information government, intermediaries or individuals so that all parties are informed.

e.) It is an adverse selection problem as the students are lacking freedom in their country thus they are seeking freedom by migrating. It can be reduced by increasing the security at the border between Iran and Iraq so that the students are forced to stay in their country.

f.) It is a moral Hazard problem because the people of Iran have been denied there freedom by the government. Thus it can be reduced when the freedom movements within Iran are supported to respond to the actions of the government.

g.) It is an adverse selection because the depressed person transfers the risk of committing suicide to the insurance company since he is in a dangerous lifestyle that is depressed. However, a clause in the life insurance policy saves the insurance company from paying in the case of suicide.

2. Lemons problem will be severe in bonds issued by the dictatorship government because in dictatorship government there is less information given about the bonds unlike in democratic governments where more information is given.

3.

a) They help the stakeholders of an organization to monitor the activities of the management executives so that to reduce the principle-agent problem effect.

b) Stock broker’s commission does not address any asymmetric problem as it does not reflect a report of moral hazard problem or the adverse selection problem.

c) Private production and sale of information like the bond rating agencies addresses asymmetric problem through the collection and summary of the information for publicity thus making all people to be aware.

d) Financial intermediation helps individual investors to collect information borrowers and issuers that help address asymmetric problem.

e) Collateral ensures that a borrower looses something in case he or she fails to repay the amount borrowed. This is because a borrower who lacks what to lose from a defaulting loan has an incentive of engaging in a risky activity with the money borrowed since they have an upward risk but lack a downward risk.

4. Yes, it is an adverse selection because those seeking to marry the rich people know more about why they want to marry them but the rich people do not know. Those seeking to marry the rich are only attracted to them by the money but not partners for life.

References

Dembe, Allard E. and Boden, Leslie I. (2000). "Moral Hazard: A Question of Morality?" New Solutions

Chiappori, P. A.; Salanie, B. (2000). "Testing for Asymmetric Information in Insurance Markets". Journal of Political Economy 108 (1): 56–78

Hart, Oliver; Holmström, Bengt (1987). "The theory of contracts". In Bewley, T. Advances in Economics and Econometrics. Cambridge University Press