University of Fort Hare

Department of Economics
Micro and Macroeconomics- ECO311/E
TEST 1 2020
Hours:
Marks: 50

This paper consists of 5 pages including the cover page

Internal Examiner
Prof FM Kapingura
Ms N Ngonyama

Instructions

Answer ONE Question from Section A. Answer ONE Question from Section B
Make use of relevant contemporary examples where applicable. The graphical illustrations must be
clearly shown.
SECTION A (Choose ONE question)

Question 1:

You are the president of Matatiele, a small island nation that has never engaged in
international trade. You are considering the possibility of opening the economy to
international trade. The chief economist of the island’s only labour union, to which every
worker belongs, tells you that free trade will reduce the real purchasing power of labour, and
you have no reason to doubt him. You are determined to remain in office, and need the
union’s support in order to do so. The union will never support a candidate whose policies
adversely affect the welfare of its members. Discuss the best approach you will follow
based on gains from trade under general equilibrium analysis.
(25)

Answer
 OR

Using general equilibrium analysis, and taking into account feedback effects, analyze the
following:

a. The likely effects of outbreaks of disease on chicken farms on the markets for chicken
and pork. (12)
b. The effects of increased taxes on airline tickets on travel to major tourist destinations
such as Cape Town and Durban and on the hotel rooms in those destinations.
(13)

Answer

a. The likely effects of outbreaks of disease on chicken farms on the markets for
chicken and pork.
If consumers are worried about the quality of the chicken, then they may choose to
consume pork instead. This will shift the demand curve for chicken down and to the
left and the demand curve for pork up and to the right. Feedback effects will partially
offset the shift in the chicken demand curve, because some people may switch back to
chicken when the price of pork rises. This will shift the demand curve for chicken
back to the right by some amount, raising the price of chicken and shifting the
demand curve for pork a bit further to the right. Overall, we would expect the price of
chicken to drop, but not by as much as if there were no feedback effects. The price of
pork will increase, perhaps by more than the increase in the absence of feedback
effects. The other possibility is that the outbreaks of disease cause a reduction in
supply of chicken. This would increase the price of chicken, which would then lead to
an increase in demand for pork. The price of pork would increase in response, which
would boost the demand for chicken by some (probably small) amount, raising the
price of chicken again. This would increase the demand for pork some more, and so
on. Ultimately these effects will peter out, but the final increases in prices will be
greater than if there had been no feedback effects.

b. The effects of increased taxes on airline tickets on travel to major tourist destinations
such as Florida and California and on the hotel rooms in those destinations.
The increase in tax raises the price of airline tickets, making it more costly to fly. The
resulting increase in ticket prices would reduce the quantity of airline tickets sold. This in
turn would reduce the demand for hotel rooms by out-of-town visitors, causing the demand
curve for hotel rooms to shift down and to the left and reducing the price of hotel rooms. For
the feedback effects, the lower price for hotel rooms may encourage some consumers to
travel more, in which case the demand for airline tickets would shift back up and to the right,
partially offsetting the initial decline in quantity demanded. The increase in airline demand
would increase the demand for hotel rooms, causing hotel room prices to increase somewhat.
In the end, we would still expect reduced quantities of both airline ticket sales and hotel
rooms, higher airline ticket prices (due to the tax) and reduced prices for hotel rooms.

SECTION B (Choose ONE question)

Question 3:

In the United States of America, some households - particularly those with low incomes have
difficulty in obtaining regular loans due to lack of credit history and collateral. However
these households participate in the subprime market, where they can get a loan only if they
pay more than prime customers who are deemed creditworthy borrowers. In recent years,
firms that make car loans have handled the problem of defaults better than banks that provide
mortgages, which helps explain why the mortgage market melted down as evidenced during
the 2007 – 2008 Global financial crisis unlike the car financing. Discuss. NB: You are
expected to discuss about the problem of moral hazard and adverse selection in each of
the markets, showing how they arise and the possible mitigation means in place, with a
specific focus on the US explain if the statement that firms that make car loans have
handled the problem of defaults better than banks that provide mortgages, which helps
explain why the mortgage market melted down as evidenced during the 2007 – 2008
Global financial crisis unlike the car financing.
(25)

Answer

Moral hazard

Before the financial crisis, financial institutions' expected that regulating authorities would
not allow them to fail due to the systemic risk that could spread to the rest of the economy.
The institutions holding the loans that eventually contributed to the downfall were some of
the largest and most important banks to businesses and consumers. There was the expectation
that if a confluence of negative factors led to a crisis, the owners and management of the
financial institution would receive special protection or support from the government.
Otherwise known as moral hazard. 

There was the presumption that some banks were so vital to the economy, they were
considered "too big to fail." Given this assumption, stakeholders in the financial institutions
were faced with a set of outcomes where they would not likely bear the full costs of the risks
they were taking at the time.

Another moral hazard that contributed to the financial crisis was the collateralization of
questionable assets. In the years leading up the crisis, it was assumed lenders
underwrote mortgages to borrowers using languid standards. Under normal circumstances, it
was in the best interest of banks to lend money after thoughtful and rigorous analysis.
However, given the liquidity provided by the collateralized debt market, lenders were able to
relax their standards. Lenders made risky lending decisions under the assumption they would
likely be able to avoid holding the debt through its entire maturity. Banks were offered the
opportunity to offload a bad loan, bundled with good loans, in a secondary
market through collateralized loans, thus passing on the risk of default to the buyer.
Essentially, banks underwrote loans with the expectation that another party would likely bear
the risk of default, creating a moral hazard and eventually contributing to the mortgage crisis.

OR

Question 4

The mortgage brokers that originated the loans often did not make a strong effort to evaluate
whether the borrower could pay off the loan, since they would quickly sell (distribute) the
loans to investors in the form of mortgage-backed securities. This originate-to-distribute
business model was exposed to principal-agent problems (also referred to more simply as
agency problems), in which the mortgage brokers acted as agents for investors (the
principals) but did not have the investors’ best interests at heart. Once the mortgage broker
earns his or her fee, why should the broker care if the borrower makes good on his or her
payment? The more volume the broker originates, the more he or she makes. Risk-loving
investors lined up to obtain loans to acquire houses that would be very profitable if housing
prices went up, knowing they could “walk away” if housing prices went down. The principal-
agent problem also created incentives for mortgage brokers to encourage households to take
on mortgages they could not afford, or to commit fraud by falsifying information on a
borrower’s mortgage applications in order to qualify them for their mortgages. Compounding
this problem was lax regulation of originators, who were not required to disclose information
to borrowers that would have helped them assess whether they could afford the loans. Using
your knowledge of principal-agent-problem, discuss the solutions available to mitigate
the principal-agent-problem in the mortgage market. Explain whether this illustrate
adverse selection or moral hazard.
(25)

Answer
Moral hazard-Moral hazard is the risk that one party has not entered into the contract
in good faith or has provided false details about credit capacity. In a moral hazard situation,
one party entering into the agreement provides misleading information  because they believe
that they won't face any consequences for their actions
 In this case the mortgage broker working for an originating lender have been encouraged
through the use of incentives, such as commissions, to originate as many loans as possible
regardless of the financial means of the borrower. Since the loans were intended to be sold to
investors, shifting the risk away from the lending institution, the mortgage broker and
originating lender experienced financial gains from the increased risk while the burden of the
aforementioned risk would ultimately fall on the investors.
Borrowers who began struggling to make their mortgage payments also experienced moral
hazards when determining whether to attempt to meet the financial obligation or walk away
from loans that were becoming more difficult to repay. As property values decreased,
borrowers were ending up deeper underwater on their loans. The homes were worth less than
the amount owed on the associated mortgages. Some homeowners may have seen this as an
incentive to walk away, as their financial burden would be lessened by abandoning a
property.
Solutions to moral hazard

The main weapon against moral hazard is monitoring, which is just a fancy term for paying

attention! No matter how well they have screened (reduced adverse selection), lenders and

insurers cannot contract and forget. They have to make sure that their customers do not use the

superior information inherent in their situation to take advantage. Banks have a particularly easy

and powerful way of doing this: watching checking accounts. Banks rarely provide cash loans

because the temptation of running off with the money, the moral hazard, would be too high.

Instead, they credit the amount of the loan to a checking account upon which the borrower can

draw funds. (This procedure has a second positive feature for banks called compensatory

balances. A loan for, say, $1 million does not leave the bank at once but does so only gradually.

That raises the effective interest rate because the borrower pays interest on the total sum, not just

that drawn out of the bank.) The bank can then watch to ensure that the borrower is using the

funds appropriately. Most loans contain restrictive covenants, clauses that specify in great detail

how the loan is to be used and how the borrower is to behave. If the borrower breaks one or

more covenants, the entire loan may fall due immediately. Covenants may require that the

borrower obtain life insurance, that he or she keep collateral in good condition, or that various

business ratios be kept within certain

parameters.www.toolkit.cch.com/text/P06_7100.asp Often, loans will contain covenants

requiring borrowers to provide lenders with various types of information, including audited

financial reports, thus minimizing the lender’s monitoring costs.

Another powerful way of reducing moral hazard is to align incentives. That can be done by

making sure the borrower or insured has some skin in the game,www.answers.com/topic/skin-

in-the-game that he, she, or it will suffer if a loan goes bad or a loss is incurred. That will induce

the borrower or insured to behave in the lender’s or insurer’s best interest. Collateral, property

pledged for the repayment of a loan, is a good way to reduce moral hazard. Borrowers don’t

take kindly to losing, say, their homes. Also, the more equity they have—in their home or

business or investment portfolio—the harder they will fight to keep from losing it. Some will still

default, but not purposely. In other words, the higher one’s net worth (market value of assets

minus market value of liabilities), the less likely one is to default, which could trigger bankruptcy
proceedings that would reduce or even wipe out the borrower’s net worth. This is why, by the

way, it is sometimes alleged that you have to have money to borrow money. That isn’t literally

true, of course. What is true is that owning assets free and clear of debt makes it much easier to

borrow.