Chapter 16 — Exercises
Section A — Adverse selection
A1. Apply Akerlof's lemons model to the used-car market. Walk through the five steps of the quality spiral. Under what conditions does the market collapse entirely?
A2. Apply the lemons model to the health insurance market (briefly — you covered this in Ch 14). How does adverse selection threaten insurance pools? How does the ACA's individual mandate address it?
A3. Apply the lemons model to the labor market. An employer can't observe a job applicant's true ability. What happens to the quality of the applicant pool if the employer offers below-market wages?
A4. Apply the lemons model to online dating. One side of the market has private information about their qualities. How does the adverse selection problem manifest? What mechanisms do dating platforms use to mitigate it?
A5. Not all markets suffer from the lemons problem equally. Identify a market where asymmetric information is severe and one where it is mild. Explain why the severity differs.
Section B — Signaling and screening
B1. Michael Spence's signaling model says a college degree can be valuable even if college teaches you nothing — purely as a signal of ability. Explain why the signal is credible. What makes it costly? Why can't a low-ability person fake the signal?
B2. A used-car dealer offers a 2-year warranty on every car sold. Apply the signaling framework: why does this signal quality? Would a lemon seller offer the same warranty?
B3. An insurance company offers two plans: Plan A (high deductible, low premium) and Plan B (low deductible, high premium). Explain how this menu screens applicants into healthy and sick groups without the insurer needing to know who is who.
B4. Job interviews and probationary periods are screening mechanisms. Explain how each works using the screening framework.
B5. Find a real example of signaling in your own life (a credential, a brand choice, a warranty you've seen). Explain what information it conveys and why the signal is credible.
Section C — Reputation systems
C1. How does eBay's seller rating system reduce the adverse selection problem in online auctions?
C2. Uber's driver rating system lets riders rate drivers from 1 to 5 stars. Drivers with low ratings can be deactivated. Apply the reputation framework: how does this reduce moral hazard on the driver's side?
C3. Amazon product reviews are sometimes faked. If fake reviews become common enough, what happens to the effectiveness of the reputation system? Apply the lemons logic.
C4. Reputation systems work best for repeat transactions. Why don't they work as well for one-shot transactions (like buying a house)?
Section D — Moral hazard
D1. Distinguish adverse selection from moral hazard using the insurance market as the example. Which problem occurs before the contract? Which occurs after?
D2. An employee is paid a fixed salary regardless of output. Apply the moral hazard framework: what is the hidden action? What is the principal-agent problem?
D3. "Too big to fail" is a moral hazard problem. Explain why a bank that believes the government will rescue it in a crisis takes on more risk.
D4. Design a compensation contract for a CEO that reduces moral hazard. What features should it include? (Hint: think about stock options, clawbacks, and performance metrics.)
Section E — The 2008 crisis
E1. Walk through the four levels of information failure in the 2008 crisis: mortgage origination, securitization, CDS insurance, and credit rating. At each level, identify whether the problem is adverse selection, moral hazard, or both.
E2. "The 2008 crisis was caused by greed." Evaluate using the information framework. Was greed the fundamental problem, or was it information failure that allowed greed to produce systemic damage?
E3. Post-crisis reforms (Dodd-Frank, stress testing, capital requirements) are designed to address information failures. Pick one reform and explain which specific information problem it addresses.
E4. Could a better reputation system for financial products have prevented the 2008 crisis? What would it look like?
Section F — Policy debate
F1. "Government should require all sellers to disclose everything they know about product quality." Apply the information framework. Would this solve the lemons problem? What are the costs of mandatory disclosure?
F2. "The government should guarantee all bank deposits (with no limit)." Apply the moral hazard framework. What would happen to bank behavior?
F3. "Credit rating agencies should be prohibited from being paid by the issuers they rate." Evaluate. What alternative funding model could work?
Section G — Data lookup
G1. Look up the history of AIG's credit default swap positions before the 2008 crisis. How much CDS protection did AIG sell? How much did it set aside in reserves?
G2. Look up the Dodd-Frank Act's major provisions. Which ones are designed to address moral hazard? Which address adverse selection?
Section H — Reflection
- Have you ever been on the "losing" side of an information asymmetry (bought a lemon, accepted a job without knowing the true conditions, signed a contract you didn't fully understand)?
- Which of the three solutions (signaling, screening, reputation systems) do you find most effective in your own experience?
- The 2008 crisis destroyed trillions of dollars of wealth. Could it have been prevented with better information alone, or were other factors (regulation, incentives, political choices) necessary?
Selected answers in appendices/answers-to-selected.md.