l. TRUE OR FALSE: The following is an example of Moral Hazard A manager does not observe the amount of effort the worker is exerting, and because of that, the total level of production is lower than in the case where effort is observable. 2. TRUE OR FALSE: The following is an example of Asymmetric Information A manager does not observe the intrinsic, immutable ability of different workers, and because of that, they hire some workers who are not productive and do not hire other workers who are productive. 3. Consider a used car market where some used cars are \"lemons", or have underlying issues that are undetectable until after sale. Which of the following policies would NOT reduce asymmetric informa tion? (a) Truthful information on why the used car is being sold (b) A mechanic's overview on each used car and what existing issues it may have. (c) Informing used car market buyers of what share of the new car market are lemons. (d) Used Car Dealerships lowering prices for cars which have been resold to the same dealership multiple times. (e) None of the above examples can help reduce market failures from information asymmetries. These next questions examine the problem of lending money to entrepreneurs, possibly in the presence of informational frictions. Here is the basic setup. Entrepreneurs start with initial wealth W0 2 l. They have a project to create a startup, which requires 2 in initial investment. If the startup is successful, it will be worth 4 in the end (that is, the total prot associated with the investment is 42:2). On the other hand, if the startup fails, it will be worth zero. Each item below species the probability of success, along with the utility function of the entrepreneur. Entrepreneurs may try to create the st artup or not. If not, the nal wealth is equal to the initial wealth. If they want to create the startup, they must get a loan from a bank, because the initial investment is more than their initial wealth. We will assume that banks are riskrneutral, so they make choices that maximize their expected prot associated with the lending operation. Because the startup will be set as a Limited Liability Company (LLC), we will assume that, if the project fails, the bank will just lose the money it loaned. So the loan contracts specify two things: (i) the amount loaned, L; and (ii) the amount the entrepreneur pays back to the bank if the project is successful, R. Regardless of the outcome, the player keeps their initial wealth mg. The utility of the entrepreneur over nal wealth is Mm) = l 092(10]. . Suppose that the probability of success is a constant p = 3/4 = 75%, and that the amount loaned is L = 2. What must be the pay back amount R so that the bank achieves zero expected prots with the loan? . Suppose that the probability of success is a constant p : 2/ 3, the amount loaned is L : 2, and that the payback amount is R = 3. What is the expected utility of the entrepreneur if they create and not create the startup, respectively? (e) E[u(W)] = 0 ifstartup is created, E[e(W)] = 0 if not (b) E[u(W)] = 1 ifstartup is created, E[u(W)] =1 if not (e) E[e(W)] = 2/3 if startup is created, E[e(W)] = 0 if not (d) E[u(W)] : 4/3 if startup is created, E[e(W)] : 0 if not (e) We do not have enough information to calculate the expected utilities. Information for Next 2 Questions: Now suppose that the entrepreneur can choose to use the loaned money for its own consumption, instead of investing in the rm. If they do that, the startup will fail for sure, and the entrepreneur's nal wealth is W9 + L. Assume that the bank cannot observe whether the money was used appropriately or not, and thus cannot get the money back if the entrepreneur did not invest it in the startup. They only get some payment back if the entrepreneur takes the loan, invests the money, and the startup ends up being successful. The probability of success in case of investment is 2/3. 6. The bank can choose to oer loans or not. If oered, the loans have L : 2 and R : 3. The entrepreneur then decides whether to take up the loan, and if so, whether to invest the money or use it for personal consumption. What happens in this market? (a) The entrepreneur will take up the loan, and not invest. (b) The bank does not offer a loan because of a moral hazard issue. (c) The bank is indierent between offering the loan or not. (d) The entrepreneur will take up the loan, and invest. (e) The bank does not offer a loan because of an adverse selection issue. 7. Now suppose there are several entrepreneurs in a small neighborhood, all of which know each other. The bank organizes the following micronanceistyle lending program: a The bank will offer a loan to one of the entrepreneurs from the neighborhood, randomly chosen, withL=2andR=3. a If that rst entrepreneur takes up the loan but does not pay back (either because the project failed or because the entrepreneur did not invest the money), then the bank stops lending at the neighborhood. a If that entrepreneur's startup succeeds and pays back R to the bank, the bank will randomly choose another entrepreneur to offer a similar loan. a If that second entrepreneur pays back the loan, the bank proceeds to the next entrepreneur; the rst time an entrepreneur fails to pay back, the back stops lending in the neighborhood. Because they are all friends, they are able to see if an entrepreneur takes money from the bank and uses it for himself, instead of investing in the startup. Also assume that neighbors can collectively punish entrepreneurs who take up the loans and not invest (for example, not helping them with their tasks, treating them badly in public, etc). They would not punish an entrepreneur who invests, but whose startup fails out of bad luck. Choose the option that best characterizes how this situation might be dierent from the one in the previous question. (a) This lending program will reduce the odds that the bank will lend to these entrepreneurs. 10. (b) This lending program does not make any difference because people hate banks; they would actually praise the entrepreneur who does not pay back. (c) This lending program can increase the odds that the bank will lend to these entrepreneurs, and that startups will be created. That's because the entrepreneur who takes up the loan has an incentive to invest: avoiding social punishment. (d) This lending program does not make any diHerence because, knowing about the possibility of social punishment, the rst entrepreneur would prefer not to take up the loan. (e) This lending program does not make any difference because the entrepreneurs are indifferent between accepting the loan or not. They do not care whether the loan would be available for them in the future, and thus have no incentives to punish an entrepreneur who does not pay back the bank. Infomstz'on for last three questions: Now suppose that there are two types of entrepreneur: skilled and unskilled. Skilled entrepreneurs have a probability p : 2/ 3 of success if they get the loan. Unskilled entrepreneurs have zero chance of being successful. Despite that, assume that unskilled entrepreneurs want to take up the loan, because it is cool to say you have a startup. The bank does not observe skill. The share of skilled entrepreneurs is s. . TRUE OR FALSE: If L = 2, R = 6, and s = 0.5, then the bank would have zero expected prots, but entrepreneurs would never take up the loan. . TRUE OR FALSE: If the loan amount is L : 2, the payback amount is R : 3, and the share of skilled entrepreneurs is s = 0.9, then the bank will have positive expected prots. Now suppose that there are several entrepreneurs in a small neighborhood and the bank organizes a group lending program exactly like in question 7. The neighbors know who is skilled and who is not. They can collectively punish unskilled entrepreneurs who take up the loans. They would not punish an skilled entrepreneur who takes up the loan, but whose startup fails out of bad luck. Choose the option that best characterizes how this situation might be different from the one in the previous two questions. (a) This lending program does not make any difference because, knowing about the possibility of social punishment, no entrepreneur would take up the loan, regardless of skill. (b) This lending program does not increase the odds that the bank will lend, because regardless of parameters, there is no market failure to be solved. (c) This lending program does not make an}r difference because the entrepreneurs are indifferent between accepting the loan or not. They do not care whether the loan would be available for them in the future, and thus have no incentives to punish an unskilled entrepreneur who takes up the loan. (d) This lending program can increase the odds that the bank will lend to these entrepreneurs, and that startups will be created. That's because social punishment can preclude unskilled entrepreneurs from taking up the loan. (e) This lending program will reduce the odds that the bank will lend to these entrepreneurs