Explain how incomplete information causes each of the following situations and why the equilibrium in each of these situations is not Pareto optimal:
(i) signaling,
(ii) adverse selection, and
(iii) moral hazard.
(i) Signaling occurs when people are unable to directly observe some desirable characteristic. People instead rely on a signal to indicate when this characteristic is present. The resulting outcome is not Pareto optimal because resources are being wasted in obtaining the signal.
(ii) Adverse selection occurs when sellers have more information than buyers, or vice versa. For example, the seller of a used car knows more about the car's quality than does the buyer, and the person buying insurance knows more about his risks than does the company selling the insurance. High-quality products and good risks tend to be driven out of the market when adverse selection exists. This situation is not Pareto optimal, because everyone would be better off if the buyers or sellers voluntarily disclosed their additional information.
(iii) Moral hazard occurs because a person takes more risks when he is insured. Even if the insured person promises to remain as careful as ever, the insurance company does not have the information to determine if this promise is being kept. Consequently, moral hazard makes insurance premiums higher. This situation is not Pareto optimal, because if moral hazard were eliminated, then insurance premiums could fall and make everyone better off.
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A) surplus; rise B) surplus; fall C) shortage; rise D) shortage; fall
Wilbur Rickhiser, a financial advisor, recently told one of his clients: "The biggest mistake you can make is to hold onto a stock for too long in order to avoid a loss
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Which of the following is not true of Usury laws that set maximum interest rates?
A. They are designed to protect the consumer. B. They interfere with the market allocation process. C. They have an effect only if the market rate is higher than the legal maximum. D. They are analogous to a price floor.
If the Federal Reserve raises its target inflation rate, the monetary policy reaction function ________ and the aggregate demand curve ________.
A. shifts upward to the left; shifts to the right B. shifts downward to the right; shifts to the left C. shifts upward to the left; shifts to the left D. shifts downward to the right; shifts to the right