Market failure: asymmetric information practice questions.

An insurance company offers a single health insurance premium to all customers. Which outcome best illustrates adverse selection?

• Insured customers begin to take more risks because they no longer bear the full cost of illness
• Mostly high-risk individuals buy the policy, while low-risk individuals opt out
• The insurer raises premiums simply to increase its profit margin
• Fully informed customers choose the cheapest policy available

Answer: Mostly high-risk individuals buy the policy, while low-risk individuals opt out

Adverse selection occurs before the contract: high-risk buyers, knowing their own risk better than the insurer, are the most likely to purchase at a uniform premium, worsening the insurer's risk pool.

A driver becomes noticeably less careful after purchasing comprehensive car insurance. This behaviour is an example of:

• adverse selection
• screening
• signalling
• moral hazard

Answer: moral hazard

Moral hazard arises after a contract is agreed: once insured, the driver no longer bears the full cost of an accident, so the incentive to take care falls.

In a second-hand car market where only sellers know the true quality of each vehicle, economic theory predicts that:

• high-quality cars are withdrawn, lowering the average quality traded
• buyers offer higher prices because they assume every car is high quality
• sellers of low-quality cars are the first to leave the market
• prices fully reveal quality, so the market reaches an efficient equilibrium

Answer: high-quality cars are withdrawn, lowering the average quality traded

Since buyers only pay a price reflecting average quality, owners of good cars find the price too low and withdraw, so poor-quality cars (lemons) come to dominate the market.

Which of the following is the best example of signalling by the better-informed party in a transaction?

• An insurer requiring applicants to complete a detailed medical questionnaire
• A government agency publishing hygiene ratings for restaurants
• A used-car dealer offering an extended warranty on its vehicles
• A buyer hiring a mechanic to inspect a car before purchase

Answer: A used-car dealer offering an extended warranty on its vehicles

Signalling is an action by the informed party (the seller) to credibly convey hidden quality; a warranty is costly for a seller of bad cars to offer, so it signals quality. The other options are screening or government provision of information.

A bank asks loan applicants to provide detailed financial records and credit histories before granting credit. This is an example of:

• signalling by the borrower
• screening by the less-informed party
• moral hazard on the part of the bank
• provision of a public good

Answer: screening by the less-informed party

Screening is undertaken by the party lacking information (the bank) to uncover the hidden characteristics of the other party before the contract is made.

Which of the following is a government response to asymmetric information rather than a private, market-based response?

• Firms offering money-back guarantees to customers
• Workers acquiring university degrees to signal their ability
• Compulsory licensing of doctors before they may practise
• Insurance companies including deductibles (excesses) in policies

Answer: Compulsory licensing of doctors before they may practise

Licensing and regulation are government interventions that guarantee minimum standards where consumers cannot judge quality; the other options are private responses (signalling, screening, guarantees).