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Moral Hazard

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Managerial Economics

Answer each of the following questions. For the multiple choice questions, state your answer and provide justification for each of your answers. The justification may be as brief as is reasonable. Make sure you clearly state your reasoning behind each of your answers for the problems (#s 13-15).

1. A bidders' value for a good may be low ($2), medium ($5), or high ($7). There are an equal number of potential bidders having each value. Suppose two bidders show up for an auction at which the good is offered. What is the best estimate of the expected revenue from the auction assuming there is no minimum bid increment?
a. $4.11
b. $3.99
c. $3.56
d. $5.00
Answer c $3.56
There may be 9 different combination of bidders with equal probability. Since, there is no minimum bid increment, the winner will pay an infinitesimal small amount above the bidder with smaller value.
Expected Revenue = 1/9*(Min (2,2)+ Min (2,5)+ Min (2,7)+ Min (5,2)+ Min (5,5)+ Min (5,7)+ Min (7,2)+ Min (7,5)+ Min (7,7))=$3.56

2. Suppose that you have 2 buyers. The first buyer values your product at $10, and the second buyer values your product at $6. You estimate that the probability of getting a high valued customer is 40%. Your marginal costs are $3. What is your optimal price and expected profit?
a. Price at $6, Profit = $1
b. Price at $6, Profit = $3
c. Price at $10, Profit = $1
d. Price at $10, Profit = $4
Answer: Price at $6, Profit = $3
At price $6, the expected profits =100%*$6 - $3 = $3 (Both buyer will $10 value and $6 value will buy at $6)
At price $10, the expected profits =60%*0+40%*10-$3=$1 (only buyer will $10 value will buy and buyer with $6 value will not buy).

3. An oral auction with values of $4, $6, $9, $12, $13, and $15 is currently taking place. What will the winning bidder pay?
a. 10
b. 11
c. 13
d. 15
Answer d.15
In oral auctions, in which announced bids escalate until only one bidder remains. Since, bidding one's true valuation for the object being sold weakly dominates every other bidding strategy. The last bid will be by the person valuing the good at $15. Thus, the winning bidder will pay $15.

4. The demand for insurance arises from people who are:
a. Risk-seeking
b. Risk-neutral
c. Risk-averse
d. None of the above
Answer c. Risk averse
The buyers of insurance are risk averse whereas the sellers of insurance are risk neutral. Since risk averse people are willing to pay premium to avoid the risk, the insurance companies make profits while taking over risk from such individuals.

5. Your firm is considering investing in a new project. If the economy is strong (30% probability), you expect an NPV of $500,000; if the economy is normal (50% probability), you expect an NPV of $400,000; and if the economy is weak (20% probability), you expect an NPV of $300,000. What is the expected NPV of the project?
a. $390,000
b. $400,000
c. $410,000
d. None of the above
Answer c. $410,000
Expected NPV = 30%*500000+50%*400000+20%*300000=410000

6. Which of the following is an example of an effective screening technique?
a. A car maker advertising the high-quality of their car
b. A customer providing an insurance company with his/her credit report
c. A company asking the average speed you drive
d. A person who decides to pursue his MBA
Answer b. A customer providing an insurance company with his/her credit report
A credit report is an effective way to understand the paying capacity of the insured. MBA could be a good screening device for certain jobs, but here nothing is mentioned about the job. Thus, a decision to pursue MBA in itself cannot be a screening technique. For other two options no method is suggested to assess the claim.

7. If you were attempting to reduce the possibility of moral ...

Solution Summary

Moral Hazard and other concepts are explained.