IFS

Assignment Questions 1

B.Com 2017

The answer key will be uploaded next weekend

MCQs

1. When will adverse selection occur in a transaction between two people?

a. When the transaction has asymmetric information
b. When the transaction has complete information
c. When the transaction has incomplete information
d. When the transaction has no information

2. Why do banks use collateral when lending?

a. It incentivizes the borrower to choose the safer project over the risky one.
b. It incentivizes the borrower to increase the amount of the loan taken.
c. It incentivizes the borrower to not take a loan.
d. It incentivizes the borrower to reduce the amount of repayment as collateral to cover the loan’s

cost.

3. What will happen if a lender charges a 20% interest rate for loans when the market rate is 10%?
a. The majority of people interested in the lender's loans will be high-risk
b. The majority of people interested in the lender's loans will be low-risk
c. There will be half as much demand for the lender's loans since the interest rate is twice the market
equilibrium
d. There will be no demand in the lender's loans as the interest rate is above the market equilibrium

4. A new study finds that smokers skip their dental treatments 40% more frequently than non-
smokers. Which is likely to be TRUE under asymmetrical information?
a. Health insurance companies should charge a higher insurance premium for someone who
received fewer dental fillings than the average, as they are more likely to be smokers
b. Health insurance companies should charge a lower insurance premium for someone who received
fewer dental fillings than the average, as they are less likely to be smokers
c. Health insurance companies should make use of dental records to reduce adverse selection for
insurance applications
d. Health insurance companies should not use dental records to reduce adverse selection in
insurance applications

Descriptive questions

1. How can the adverse selection problem explain why you are more likely to make a loan to a
family member than to a stranger?
2. If you are a shareholder of a firm called Zed, what kinds of moral hazard problems might you
worry about with manager of Zed?
 3. Why might you be willing to make a loan to your neighbor by putting funds in a savings account
earning a 5% interest rate at the bank and having the bank lend her the funds at a 10% interest
rate rather than lend her the funds yourself?

Problem questions

1. Meg and Sasha are working on a team project. Each worries that the other will do very little
work. If both decide to work they score 50 out of 50. If one works and the other lazes about, they
score 30. If neither of them work, they end up getting 0. Now reconsider the payoffs based on the
girls’ utility function. Each girl’s utility function is as follows
U= score – 0.5(hrs put into the team project) + (hrs put into the team project by the other team
mate)
They can choose to put in 10 hrs, 5hrs and 0 hrs each. Why is the second situation with revised
payoffs likely to have moral hazard? What do you think will happen? Demonstrate through the
working.
2. Sally is owns the Cool Garage. She buys and sells used cars. She can buy a used car for
$1000 and sell it for $1100 making a profit of $100. She is uncertain about the state of
the car. It might be a lemon (bad car) or a peach (good car). From her experience as a
garage owner, she knows that 20 % used cars are lemons. She also knows that it takes
$40 to repair a peach and $200 to repair a lemon. Should she buy this car?
3. Now going back to Sally’s garage story, eventually the car turns out to be a lemon. Sally
knows that John wants to buy a car to impress his mother-in-law. Sally has made minor
adjustments to the car worth $40 to make it run but it may conk out any minute. She
offers to sell John the car at the going rate $1100. Explain what is happening here.