Abe, a high-powered stockbroker in New York, inherits a farm in Illinois from a long-forgotten relative. Abe knows nothing about farming, however, so he hires Bill to farm the land and pays Bill out of the proceeds. Two factors affect how much revenue the farm generates: luck and Bill's effort level. If there's bad luck -- insect infestations, bad weather, etc. -- then it doesn't matter how much Bill works, the farm only produces $1 million in revenues. If there's good luck, then if Bill works hard the farm produces $5 million in revenues; but if Bill doesn't put in much effort, the farm only produces $1 million.

1.1.

1.1 In the first year, Abe pays Bill a salary of $200,000 to manage the land, regardless of how much revenue is produced. Why is this not a good idea?

A) He could farm the land himself and keep the $200,000.

B) Bill has no incentive to work hard, since he gets paid the same no matter what the farm produces.

C) He could probably hire someone else for only $150,000 to manage the land

1.2 Again suppose that in the first year Abe pays Bill a salary of $200,000 to manage the land, regardless of how much revenue is produced. The economic problem in this story is known as:

A. Screening

B. Signaling

C. Adverse selection

D. Moral hazard

1.3 Which would be the most efficient way for Abe to ensure Bill works hard?

A. Offer Bill 10% of the farm's revenues as payment, rather than a salary.

B. Hire a private investigator to monitor Bill's activity.

C. Threaten to fire Bill if the farm only produces $1 million in revenue.

D. Install a video surveillance system to monitor Bill's activity.

Bill sees a classified ad offering a used DVD player for $5. On the opposite page, he sees a big color ad from a national electronics chain offering new DVD players for $50. Bill values a DVD player at $75 as long as it works, regardless of whether it is new or used.

2.1.

Suppose Bill buys the new DVD player, thinking to himself, "someone would only ask $5 for a DVD player if it didn't work well." This reasoning reflects the principle of:

a) Adverse selection

b) Signaling

c) Moral hazard

d) Screening

	2.2 Suppose that the seller of the DVD player, Al, was honest. He had a DVD player, and then his parents gave him a new one for his birthday, so rather than throw the old one away he tried to find it a new home and make a few dollars. What should Al have done to sell it successfully? a) He should have asked $20 and sold it with a guarantee that he would replace it with a new DVD player if it turned out not to work. B) He should have offered the DVD player for free to anyone who would take it. C) He should have asked $45 to show that it was a good deal. d) He should have posted a picture of the DVD player along with his ad, to make it look more attractive. 2.3 Suppose Al knows the machine works well. He thinks about asking $20 and offering a guarantee: he'll replace it with a new $50 DVD player if his turns out not to work. Then he thinks to himself, "That's not a good idea! Someone will just buy it, scratch it up, pretend it doesn't work, and get a new DVD player for $20 -- meanwhile, I'll be out $30!" Al's line of reasoning regarding his potential buyer reflects the principle of: A. Screening B. Moral hazard C. Signaling D. Adverse selection 2.4. Al is unable to sell Bill the DVD player because: I. Adverse selection can cause buyers not to buy high-quality goods because of uncertainty about their quality. II. Moral hazard can prevent sellers from offering guarantees of quality, because sellers can't be sure that buyers won't try to take advantage of the guarantee by filing false claims. A. I only B. II only C. Both I and II Ole Harry is the skipper of the Better Late Than Never, a VERY slow freighter that runs from Singapore to Los Angeles and back without making any other stops. The boredom of the voyage results in high worker turnover. He therefore has two kinds of crew members: short-term workers who lose their patience with the long, boring trip and long-term workers who are very patient and will stick with the job. Short-term workers are necessary but contribute little to the profitability of the ship. Long-term workers are highly valuable, and Ole Harry pays them a much higher wage. As a result, all new applicants tell Ole Harry that they will be long-term workers, regardless of whether they really are patient or not. 3.1. What can Ole Harry do to screen his applicants into the right jobs: that is, truly patient workers to long-term crew and truly impatient workers to short-term crew? A. Strand job applicants on a desert island, return after several months, and if they're still alive they are hired. B. Ask job applicants to stand on one foot for 10 minutes. C. Ask job applicants to sign a pledge stating "I fully intend on remaining on board for five years." D. Ask job applicants to sort his 1,500-card baseball card collection by batting average. 3.2. Suppose Ole Harry chooses to ask job applicants to sort his 1,500-card baseball card collection. If he pays his long-term crew members $1,000 per voyage and he pays his short-term crew members $300 per voyage, what must be true in order for this mechanism to screen workers effectively? I. For truly patient workers, it's worth at least $700 to have to sort the card collection. II. For truly impatient workers, its worth less than $700 to have to sort the card collection. III. For truly impatient workers, it's worth more than $700 to have to sort the card collection. IV. For truly impatient workers, it's worth less than $300 to have to sort the card collection. A. I and II B. I, II, and III C. I and IV D. III and IV

Imperfect Information and Market Behavior Abe, a high-powered stockbroker in New York, inherits a farm in Illinois from a long-forgotten relative. Abe knows nothing about farming, however, so he hires Bill to farm the land and pays Bill out of the proceeds. Two factors affect how much revenue the farm generates: luck and Bill's effort level. If there's bad luck -- insect infestations, bad weather, etc. -- then it doesn't matter how much Bill works, the farm only produces $1 million in revenues. If there's good luck, then if Bill works hard the farm produces $5 million in revenues; but if Bill doesn't put in much effort, the farm only produces $1 million. 1.1. In the first year, Abe pays Bill a salary of $200,000 to manage the land, regardless of how much revenue is produced. Why is this not a good idea? a) He could farm the land himself and keep the $200,000. b) Bill has no incentive to work hard, since he gets paid the same no matter what the farm produces. c) He could probably hire someone else for only $150,000 to manage the land 1.2 Again suppose that in the first year Abe pays Bill a salary of $200,000 to manage the land, regardless of how much revenue is produced. The economic problem in this story is known as: A. Screening B. Signaling C. Adverse selection D. Moral hazard 1.3 Which would be the most efficient way for Abe to ensure Bill works hard? A. Offer Bill 10% of the farm's revenues as payment, rather than a salary. B. Hire a private investigator to monitor Bill's activity. C. Threaten to fire Bill if the farm only produces $1 million in revenue. D. Install a video surveillance system to monitor Bill's activity. Bill sees a classified ad offering a used DVD player for $5. On the opposite page, he sees a big color ad from a national electronics chain offering new DVD players for $50. Bill values a DVD player at $75 as long as it works, regardless of whether it is new or used. 2.1. Suppose Bill buys the new DVD player, thinking to himself, "someone would only ask $5 for a DVD player if it didn't work well." This reasoning reflects the principle of: a) Adverse selection b) Signaling c) Moral hazard d) Screening 2.2 Suppose that the seller of the DVD player, Al, was honest. He had a DVD player, and then his parents gave him a new one for his birthday, so rather than throw the old one away he tried to find it a new home and make a few dollars. What should Al have done to sell it successfully? a) He should have asked $20 and sold it with a guarantee that he would replace it with a new DVD player if it turned out not to work. B) He should have offered the DVD player for free to anyone who would take it. C) He should have asked $45 to show that it was a good deal. d) He should have posted a picture of the DVD player along with his ad, to make it look more attractive. 2.3 Suppose Al knows the machine works well. He thinks about asking $20 and offering a guarantee: he'll replace it with a new $50 DVD player if his turns out not to work. Then he thinks to himself, "That's not a good idea! Someone will just buy it, scratch it up, pretend it doesn't work, and get a new DVD player for $20 -- meanwhile, I'll be out $30!" Al's line of reasoning regarding his potential buyer reflects the principle of: A. Screening B. Moral hazard C. Signaling D. Adverse selection 2.4. Al is unable to sell Bill the DVD player because: I. Adverse selection can cause buyers not to buy high-quality goods because of uncertainty about their quality. II. Moral hazard can prevent sellers from offering guarantees of quality, because sellers can't be sure that buyers won't try to take advantage of the guarantee by filing false claims. A. I only B. II only C. Both I and II Ole Harry is the skipper of the Better Late Than Never, a VERY slow freighter that runs from Singapore to Los Angeles and back without making any other stops. The boredom of the voyage results in high worker turnover. He therefore has two kinds of crew members: short-term workers who lose their patience with the long, boring trip and long-term workers who are very patient and will stick with the job. Short-term workers are necessary but contribute little to the profitability of the ship. Long-term workers are highly valuable, and Ole Harry pays them a much higher wage. As a result, all new applicants tell Ole Harry that they will be long-term workers, regardless of whether they really are patient or not. 3.1. What can Ole Harry do to screen his applicants into the right jobs: that is, truly patient workers to long-term crew and truly impatient workers to short-term crew? A. Strand job applicants on a desert island, return after several months, and if they're still alive they are hired. B. Ask job applicants to stand on one foot for 10 minutes. C. Ask job applicants to sign a pledge stating "I fully intend on remaining on board for five years." D. Ask job applicants to sort his 1,500-card baseball card collection by batting average. 3.2. Suppose Ole Harry chooses to ask job applicants to sort his 1,500-card baseball card collection. If he pays his long-term crew members $1,000 per voyage and he pays his short-term crew members $300 per voyage, what must be true in order for this mechanism to screen workers effectively? I. For truly patient workers, it's worth at least $700 to have to sort the card collection. II. For truly impatient workers, its worth less than $700 to have to sort the card collection. III. For truly impatient workers, it's worth more than $700 to have to sort the card collection. IV. For truly impatient workers, it's worth less than $300 to have to sort the card collection. A. I and II B. I, II, and III C. I and IV D. III and IV