Course - Managerial Economics

IIM BANGALORE

PROBLEM SET 8
TOPIC: Collusion and Adverse Selection/Signalling

1. Which of the following tool(s) help solve adverse selection problem in financial markets:
a. private production and sale of credit ratings for individuals and firms
b. government regulation to increase information to investors
c. use of financial intermediaries that specialize in the gathering of information about
would-be borrowers
d. inclusion of collateral requirements in loan contracts as a quality signal
e. all of the above
Options A, B & C give more information about borrowers to investors/lenders. So it helps solve
information asymmetry and the resulting adverse selection problem.

Option D is another way to solve the information asymmetry/adverse selection through the
method of signalling. High quality borrowers (Good credit scores/higher chance of repayment)
will be able to furnish the required collaterals while low-quality borrowers may not be able to
furnish collaterals. So this signals to the investors who is high-quality borrower and who isn’t.

So All of the Above are correct.

2. A warranty could solve “the lemons principle” if

a. The cost of providing a warranty is the same for high quality goods as for low quality
goods
b. Cost of providing a warranty is lower for high quality goods than for low quality goods
c. cost of providing a warranty is higher for high quality goods than for low quality goods
d. Consumers treat all sellers alike.

The warranty method works to differentiate the high quality goods from the low quality goods
only if cost of providing warranty is lower for high quality goods than for low quality goods.
The whole concept of using warranties is that high-quality producers will set a warranty duration
that low quality producers wont be able to match, as their costs will be higher, and so profits will
be lower if they choose to include a warranty. And hence they wont include warranties.

If cost is lower for low quality goods, low quality goods manufactuers too would be able to
include warranties and hence the warranty method wouldn’t work.
3. Consider a competitive insurance market exists with only two types of individuals, high-risk
and low-risk, with no transaction costs for insurance. If the initial price of insurance is higher
than low-risk individuals are willing to pay, you would expect the final equilibrium competitive
price of insurance to be:
a. somewhere between the low-risk and high-risk expected loss values.

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 b. equal to expected loss value of the high-risk individuals.
c. equal to the maximum price low-risk individuals are willing to pay
d. equal to the expected loss of low-risk individuals.

If insurance price is higher than low-risk indiviuals WTP, then low-risk individuals wont buy at
all. Only high risk individuals will buy.

However, if only high risk individuals buy, then it becomes very unprofitable for insurers as they
wont be making money from these guys. So premiums will go up to the level of the expected
loss of the high-risk individual.

(Expected loss of high -risk individual = Expected Payout of insurer. So insurer will increase
premiums to be able to atleast cover the payout to this group of people)
4. Adverse selection in health insurance markets
a. refers to the tendency of insured people to take fewer preventive actions, increasing
everyone’s costs.
b. refers to the tendency of low-risk people to opt out of insurance, increasing the price of
insurance.
c. refers to firms refusing to insure people with pre-existing conditions, leading to social
problems.
d. refers to efforts by consumers to select the lowest priced insurance on the market,
leading to pervasive disequilibrium.
Information asymmetry/adverse selection in health insurance is because insurer doesn’t know
who is high-risk person who is low-risk person. But the customer knows all about his health.
So insurer will set prices based on expected loss of average person. But this means low-risk
people wont buy it (not worth it) but high-risk people will buy it. So over time, price of insurance
will go up.
So option B is correct.

5. Which of the following is a problem of adverse selection

a. Individuals use more medical services as a result of their purchase of a health insurance
plan
b. A person takes up the hobby of bungee jumping after purchasing health insurance.
c. the lender has a problem of distinguishing good risk from bad risk borrowers.
d. the lender has a problem determining that the proceeds from a loan are being used as
the borrower stated
Same as above (Q6). Adverse selection results from the lender knowing less about the borrower
and hence not able to distinguish who is high risk vs who is low risk. Information asymmetry.

6. Mary Jones is the president of a local bank. She knows that half of the loan applicants in town
she would classify as high risk and the other half as low risk. She observes that the other banks in
town charge two different interest rates, a lower rate for low-risk borrowers, and the higher rate
for high-risk borrowers. She decides that to have an advantage over the other banks she will
offer an average rate to everyone. The likely result will be:
a. Mary's bank will be highly successful as this will provide the bank with a large
competitive advantage.
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 b. Mary's bank is likely to see a dramatic increase in both types of borrowers.
c. Mary's bank will experience adverse selection and have a disproportionate number of
high risk borrowers
d. Mary's bank will experience adverse selection and have a disproportionate number of
low risk borrowers

Mary will price the interest rate based on expected risk of average borrower which will be average
of low risk and high risk. So the interest rate will be too high for low-risk borrowers and they won’t
borrow. Only high-risk borrowers will borrow as they will find the terms attractive as they know
their own financial capabilities.
So there will be adverse selection and will have a lot of high-risk borrowers making it unprofitable.

NUMERICAL QUESTIONS
7. Consider a price competition model with two firms, 1 and 2, whose demand functions are as
follows:
𝑄1 = 90 – 3. 𝑃1 + 2𝑃2, and
𝑄2 = 90 – 3. 𝑃2 + 2. 𝑃1 .
Each firm’s marginal cost is Rs.6. This game is symmetric, and you can use this symmetry to
simplify some calculations.
a. Write down firm 1’s profit function.
This problem is a oligopoly with differentiated products problem. We know its differentiated
products as both firms have different demand functions which wont be the case if they sold
identical products.

For Firm 1
Profit = Profit per unit * Qty

Per unit profit = (P1 - 6) (Price minus marginal cost)

Qty : Q1 = 90 – 3P1 +2P2

Profit function of firm 1 = (P1 - 6) * (90 – 3P1 +2P2)

b. For any 𝑃", derive firm 1’s residual demand curve.

Question is asking what is firm 1’s demand curve (Q1 vs P1)

Q1 = (90 + 2P2) – 3P1 (Rearranging the given demand fn)

For a given P2, 90 + 2P2 is constant. So the above equatin, is similar to a

Q = a – bP form where a is constant. So this is firm 1’s residual demand curve.
c. Using profit maximization rule, what is firm 1’s optimal price given 𝑃"? That is, what
is firm 1’s reaction curve in this game?
We have profit function. For max profits d(Profits)/d(P1) = 0 ( BecauseAt maxima, the differential
is 0)

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Profit function = (P1 - 6) * (90 – 3 P1 +2P2)
Differentiating w.r.t P1 and setting to 0,

(P1 – 6)* -3 + 1*(90- 3 P1 +2 P2) = 0 (Note : Im doing differetiation by parts as it is a product of

two terms containing P1. You can also expand the product and then differentiate. Will get the same
result)

6P1 = 108 +2 P2 ;
P1 = 18 + P2/3 (This is the reaction curve for firm 1. For every price action of firm 2, we know
the optimal P1 to maximize profits from this equation)

d. Because the game is symmetric, you can obtain firm 2’s reaction curve by changing the
indices in firm 1’s reaction curve. Graph the two curves on the same axes, with firm 1’s
price on the horizontal axis and firm 2’s price on the vertical axis. Estimate from the
graph the Nash equilibrium prices.
The two demand functions in the question are symmetric. The MCs are same for both firms.

So reaction curve of firm 2 will be the mirror of firm 1.

P1 = 18 + P2/3 ( You can check this by doing the same steps we did in Part C but for firm 2)

Plotting these two on a functions on a graph and finding Nash equilibrium prices from the
intersection point.

Without using the graphs, you can find the intersection point by 2 equations, 2 unknowns and
solving.
P1 = 18 + P2/3
P2 = 18 + P1/3
Solving gives P1 = P2 =27$ (Same as on the graph)

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 e. Because the game is symmetric, there is a symmetric equilibrium. Let 𝑃# be the
common price. Write down and solve the single equation that defines a symmetric
equilibrium.

P1 = 18 + P2/3
P2 = 18 + P1/3

Observe the 2 equations are symmetric. So we can see that the solution will be P1 = P2.
Lets assume P1 = P2 = PN

So we can write the two equations as one single equation.

PN = 18 + PN/3
Solving gives PN = 27$. So P1 = P2 = 27$ (Same as we got in previous part)
(Note : This question is just prompting you to note that because the two equations are symmetric,
there is an easier way to solve by using a single equation, than the 2 equations 2unknowns method.
The result will be the same in both cases)

f. Calculate the profit of each firm in the Nash equilibrium.

Price of each firm = 27$

We find Q1 and Q2 by substituting them into the initial demand functions given.

𝑄1 = 90 – 3. 𝑃1 + 2𝑃2, and
𝑄2 = 90 – 3. 𝑃2 + 2. 𝑃1 .

So Q1 = 90 – 3*27 + 2*27 = 63 units

Similarly Q2 = 63 units.

Both have same MC = 6$ and no fixed costs.

Profits of firm 1 = (27-6)*63 units = 1323$

Profit of firm 2 will be the same (Same price, same MC, Same qty)

8. Consider the following data regarding a buyer’s willingness to pay and a seller’s minimum
price in a used car market. There is one car of each type in the market.

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 Car Buyer’s Seller’s
Quality Valuation Minimum Price
Good 90 80
Medium 60 50
Bad 30 20

a) Suppose buyers have complete information regarding a car’s quality. What is the total
surplus generated?
If buyers have full info, there is no information asymmetry. They know which car is which and
will pay between 80-90 for good cars, 50-60 for med and 20-30 for low cars.

Total Market surplus = (Buyers Max WTP – Sellers Minmum Price) * Qty sold
= (30-20)*1 + (60-50)*1 + (30-20)*1 = 30$

b) Now suppose that buyers do not have information regarding a car’s quality. Although
buyers may not know the quality of a specific car, they do know that it is equally likely
that a car is of Good, Medium or Bad quality. In such a market, what cars will be sold
on the second-hand market and at what price? What is the deadweight loss?
If buyers don’t have info, there is information asymmetry.
Probability of getting good car = prob of bad car = prob of medium car= 1/3
So expected value of car = 1/3*90 + 1/3*60 + 1/3*30 = 60$

So in this case, the buyers max WTP is 60$ as he doesn’t know what car he will get.
Since this is lower than the sellers minimum price for good cars, good car wont get sold. But
medium and lower car will get sold at 60$ each.

Deadweight Loss due to loss of info = The surplus transactions that didn’t happen = Surplus from
sale of good car = (90-80)*1 = 10$