Ans 1: a) Moral hazard arises because an individual or institution does not take the full consequences and responsibilities

of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to hold some responsibility for the consequences of those actions. Executive stock options that creates a moral hazard by forcing a fundamental conflict of interest between the management and the shareholders of a company, however, eliminating stock options and replacing them with restricted stock in employee compensation packages is a mistake with far-reaching and long-term consequences. The main thrust of this change involves basing the payout of the option on the long-term average of the stock price over the life of the option. The implementation of this change would address the moral hazard issue, preserve the value of options to corporations and employees, and, at the same time, result in a true alignment of management and long-term shareholder interests.


Adverse Selection, selecting whom to give more your money is a very important part of controlling risk. Give it to a crook, and you lose your money. Give it to someone who is not good at handling money, and you could also lose it. In fact, without information about those seeking funds, theory goes that you would have to charge an average price for your money or sale item. But an average price would cause those who are better risks or have better products to shun your offer, while those with higher risks will seek your offer, resulting in adverse selection. For a firm that repeatedly needs funds, the incentives to grant overvalued equity to employees are reduced because employees can rationally deprive the firm of fairly-priced financing after a poor stock price performance.

b) Adverse selection and moral hazard in credit markets became severe. Firms with productive uses of funds were unable to get financing. The prolonged economic contraction leads to an unemployment rate around 25%.Asymmetric Information: Adverse Selection and Moral Hazard: we defined asymmetric information along with two categories of asymmetric information—adverse selection and moral hazard

The Lemons Problem: How Adverse Selection Influences Financial Structure: we discussed how adverse selection effects the flow of capital and tools to reduce this problem Ans 1.B.: The compensation should be attributable to the agency cost to a limited extent. As if the majority of compensation is part of stock options and et al, it may lead to moral hazard and would go against the company benefits. Yes, a five year vesting schedule for the employees stock and option plans will be a superior way of disbursing compensation, as the implementation of this change would address the moral hazard issue, preserve the value of options to corporations and employees, and, at the same time, result in a true alignment of management and long-term shareholder interests. The Adverse selection and moral hazard essentially contributed to the credit crisis. Firms with greater risky proposition readily took up credit and the portfolio of bank became riskier. These firms could hide the information from the lender and hence the market was facing moral hazard. Whereas on the other hand, adverse selection took place as at the market rate firms with productive uses of funds were unable to get financing at the desired rate. However, the unproductive firms readily took up loans and defaulted.

Ans 2: a) The moral-hazard argument makes sense, however, only if we consume health care in the same way that we consume other consumer goods, and to economists like Nyman this assumption is plainly absurd. We go to the doctor grudgingly, only because we’re sick. “Moral hazard is overblown,” the Princeton economist Uwe Reinhardt says. “You always hear that the demand for health care is unlimited. This is just not true. People who are very well insured, who are very rich, do you see them check into the hospital because it’s free? Do people really like to go to the doctor? In this case, insured parties do not behave in a more risky manner that results in more negative consequences, but they do ask an insurer to pay for more of the negative consequences from risk as insurance coverage increases. For example, without medical insurance, some may forgo

medical treatment due to its costs and simply deal with substandard health. But after medical insurance becomes available, some may ask an insurance provider to pay for the cost of medical treatment that would not have occurred otherwise.Sometimes moral hazard is so severe it makes insurance policies impossible.Individuals attain better health through the increased consumption of medial care, making them more productive and netting an overall benefit to societal welfare.

b) Adverse selection in health insurance is a term describing the tendency of high-risk individuals to seek health insurance and the tendency for low-risk individuals to defer from health insurance. The healthy will avoid health insurance up until the point of requiring medical services to be paid. An example of a


low-risk individual: a healthy 25 year old male with no family history of heart disease or cancer and no insurance claims made for 10 years.


high-risk individual: a 55 year old investment banker whose parents died from cardiovascular disease, who also smokes, and is being treated for high blood pressure and diabetes. The rationale for


low-risk individuals: why pay for expensive health insurance which I almost certainly will not need in a certain time period?


high-risk individuals: why pay for my current medical bills at full price when I can just buy insurance instead to cover almost all of these expenses?

c) A variety of programs help people who suffer the misfortune of poverty. Aid to dependent children helps people who suffer the misfortune of having children to raise that they cannot financially support. Unemployment compensation pays people who suffer the misfortune of losing their jobs. Food stamps and public housing help the poor. Yet all these programs also suffer from problems of moral hazard. They increase children born out of wedlock, unemployment, and poverty.Moral hazard creates problems both for private insurance and the government. Private insurance usually does not cover 100% of

a loss and tries to keep buildings and autos insured for less than their true worth. In addition, it is usually against the law to create the misfortune that you are insured against. Finally, if the problem of moral hazard is too great, there will be no insurance coverage for the misfortune.The government can and sometimes does take a similar approach. It can give so little aid to those in distress that it provides little encouragement for people to put themselves in the situation, but it then provides little help for those in distress. As it expands a program to provide more aid to those in distress, it also encourages people to put themselves in distress. If people are paid to be poor, some will become poor. If people are paid to have children out of wedlock, some will. If people are paid to be unemployed, more will be unemployed. Thus government programs that act to insure citizens against some misfortunes have a basic tradeoff that cannot be escaped. Greater efforts to help those in need also increase actions that are considered socially undesirable.

Ans:3 a) Merger: Two or more businesses join together and operate as one organization with shared management. Economies of scale: Mergers also translate into improved purchasing power to buy equipment or office supplies - when placing larger orders, companies have a greater ability to negotiate prices with their suppliers. • Acquiring new technology - To stay competitive, companies need to stay on top of technological developments and their business applications. By buying a smaller company with unique technologies, a large company can maintain or develop a competitive edge. • Improved market reach and industry visibility - Companies buy companies to reach new markets and grow revenues and earnings. A merge may expand two companies' marketing and distribution, giving them new sales opportunities. A merger can also improve a company's standing in the investment community: bigger firms often have an easier time raising capital than smaller ones.

Joint ventures: Two or more companies share the costs, responsibility and profits of a business venture or investment. • • Advantages: enjoying growth of turnover with losing identify, way of eliminating direct competition, etc. Disadvantages: possible control struggle if 50:50 ones, cultural conflicts or disagreement in management, etc. Economies of scale: Joint ventures and strategic alliances force companies to share revenues and profits, but they also share the risk of loss and failure. Economies of scale can be achieved when two or more firms pool their resources together, maximizing efficiency based on the project's needs. Cooperative strategies also allow small companies to join together to compete against an industry giant. Companies of different sizes may also benefit from joining together. b) It would be a Nash Equilibrium since , concept of a game involving two or more players, in which each player is assumed to know the equilibrium strategies of the other players, and no player has anything to gain by changing only his own strategy unilaterally. If each player has chosen a strategy and no player can benefit by changing his or her strategy while the other players keep theirs unchanged, then the current set of strategy choices and the corresponding payoffs constitute Nash equilibrium.

c) The proposed joint venture is set to make the market share of the combined companies to rise above 90% for internet search. Thereby, the joint venture will lead to a monopoly situation in the market, which will bring down the customer surplus. This is against the anti-trust law. The monopoly is avoided by the regulatory bodies as it not only bring down the consumer surplus but also brings down the total trade in the market and hamper the economy as a whole. The justice department is likely to go against the proposed joint venture, if in case they approve of the JV, it is very probable that the joint venture will be regulated so as to preserve the dynamics of the market to prevent it from becoming a monopoly market. In the US, the antitrust law was formulated in the 19 th century. This was done in order to protect the consumer’s interest and prevent the power of monopolist to determine price in the market. In 1974, action was taken against AT&T owing to the antitrust lawsuit, it initiated by the U.S.

Department of Justice. Under the Bell System divestiture, Bell System was forced to divest its local exchange service operating companies, in return to go into the computer business of AT&T Computer Systems. By 1984, AT&T's local operations were split into seven independent Regional Holding Companies.

Ans: 6 a) Bundling consists in the sale of two or more differentiated products in fixed combination in a single package. It can be considered as a subcategory of tie-in sales, which apply to situations where the sale of one product is somehow made conditional on the purchase of another. There is no need to illustrate the prevalence of this practice in business life: consider, for example, travel companies bundling flights, a hotel, car rental andaccommodation in a vacation package. The following list gives us an idea ofsome of the incentives that have been put forward for a firm to bundle: - To leverage its market power in other markets, reduce rivals' profitsand drive them out of the market, - To achieve better price discrimination, - To save production and transaction costs, - To deter entry and/or to harm entrants' profitability, - To credibly commit to aggressive innovative investment and cost cuttingR&D, - To exploit forms of complementarily between components. Ans: 6 b) The company should bundle the products and set the price as $19. This way company is just charging the reservation price of 3 to 7 years old, which is the highest. The profit accrued in this case will be $11 per bundle. The next best strategy is to charge $17 per bundle, which would lead to a profit of $9 per bundle. This way per bundle profit will be

highest in the first case; however, the number of subscriptions will reduce in the first case. Thus depending on the number of connections the firm wants to give out, it may select the price of the bundle.

Ans: 7 a) The type of price discrimination that exists in this situation is Peak-load pricing that is Demand for some products may peak at particular times. Rush hour traffic Electricity - late summer afternoons Hotels are more expensive in summer

b) The evolution in electric rates are phasing out of declining block rates under which successive blocks of energy are charged at lower costs. Rates are based on marginal costs rather than on the average costs incurred in the past. In addition, there are numerous concepts- such as lifetime rates; interruptible rates etc. that are undergoing scrutiny and development. The rapid changes in the cost of electricity, responses utilities ad their regulatory agencies, and the actions of the public service commission.

c) In this case the kind of price discrimination is Second Degree price discrimination, since it is the practice of charging different prices per unit for different quantities of the same good or service: extract some, but not all of consumer surplus.

Ans: 8 a) and b) Nash equilibrium is a concept of a game involving two or more players, in which each player is assumed to know the equilibrium strategies of the other players, and no player has anything to gain by changing only his own strategy unilaterally. If each player has chosen a strategy and no player can benefit by changing his or her strategy while the other players keep theirs unchanged, then the current set of strategy choices and the corresponding payoffs constitute Nash equilibrium. The prisoner's dilemma is a fundamental problem in game theory that demonstrates why two people might not cooperate even if it is in both their best interests to do so. The Prisoner's Dilemma has the same payoff matrix as depicted for the Coordination Game, but now C > A > D > B. Because C > A and D > B, each player improves his situation by switching from strategy #1 to strategy #2, no matter what the other player decides. The Prisoner's Dilemma thus has a single Nash Equilibrium: both players choosing strategy #2 ("defect"). What has long made this an interesting case to study is the fact that D < A (i.e., "both defect" is globally inferior to "both remain loyal"). The globally optimal strategy is unstable; it is not equilibrium.

Ans: 10 a) The firms are operating in a perfectly competitive market. Thus firm should produce at P=MR=MC P = 4.2 -1.5 Q TR= P*Q= (4.2 -1.5 Q)*Q =4.2Q-1.5Q2 MR= 4.2-3Q TC = $2.2 + 0.2Q + 0.5Q2 MC= 0.2+Q MR=MC 4.2-3Q=0.2+Q

4=4Q Q=1 Optimal output per firm is = 1 Optimal output for industry is = 2 Optimal price= (MR= 0.2+1)=1.2

Ans:10 b) The collusion of firms is like a monopoly situation. In monopoly, the monopolist produce at MR=MC P = 4.2 -1.5 Q TR= P*Q= (4.2 -1.5 Q)*Q =4.2Q-1.5Q2 MR= 4.2-3Q TC = $2.2 + 0.2Q + 0.5Q2 MC= 0.2+Q MR=MC 4.2-3Q=0.2+Q 4=4Q Q=1 Optimal output for the industry = 1 Optimal price: P = 4.2 -1.5 Q P= 4.2-1.5=2.7 Optimal price=2.7


a) In order for this to be an “optimal” price, it must be the case that the marginal revenue is equal to marginal cost.

MR= P*(1+ 1/n), n= (dQ/dP)*(P/Q) Differentiating Q = 75 P-2 I-2 with respect to P dQ/dP=-150 P-3 I-2 Substituting this into the equation for the price elasticity of demand: n= (-150 P-3 I-2/75 P-2 I-2)*P n= -2 Thus, MR = P*(1+1/n) = 30(1+ 1/(−2))= 15 Since marginal revenue is equal to marginal cost, price is optimal

b) The optimal price is $30, the optimal price is given by: P= MC/(1+1/n) P= 15/(1-1/2) P=$30 c) Income elasticity is given by:

Ed= (dQ/dI)*(P/I) Differentiating Q = 75 P-2 I-2 with respect to I dQ/dI=-150 P-2 I-3 Substituting this into the equation for the income elasticity of demand: Ed= (-150 P-2 I-3/75 P-2 I-2)*P Ed= -2 A negative income elasticity of demand implies that the product is inferior goods. Thereby this product is an inferior good and an increase in income of will lead to a fall in the demand of the product.

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