Problem Set #7
- (18 Points) Adverse Selection and Moral Hazard.
a. (3 points). When Sofia buys a computer for $1,000, she knows that there is a 10% chance that it will break within the first year if she treats it with care. She is risk averse and would therefore pay up to $120 for a warranty that will replace the computer if it breaks for any reason during this period. If a risk-neutral firm offered her a warranty at this price, what would its expected profits be if it sold her a warranty at this price? Assume that she treats the computer with care.
b. (3 points). Explain how moral hazard might undermine the firm’s calculations.
c. (3 points). Alejandro is less careful than Sofia. There is a 20% change the $1,000 computer will break within the first year if he treats it with care. He is also risk averse and would pay up to $220 for a similar warranty. If a risk-neutral firm sold him a warranty for $220, what would its expected profits be? Assume that he treats the computer with care.
d. (3 points). Suppose that the firm cannot work out how is careful and who is not. Who will buy the warranty at a price of $120 (Sofia’s reservation price)? What would the firm’s profits be if it offered to sell its warranty to anyone who wants it at this price? Assume that the customers will treat the computer with care.
e. (3 points). Suppose that the firm cannot work out how is careful and who is not. Who will buy the warranty at a price of $170 (the average of Alejandro and Sofia’s reservation prices)? What would the firm’s profits be if it offered to sell its warranty to anyone who wants it at this price? Assume that the customers will treat the computer with care.
f. (3 points). Suppose that the firm cannot work out how is careful and who is not. Who will buy the warranty at a price of $220 (Alejandro’s reservation price)? What would the firm’s profits be if it offered to sell its warranty to anyone who wants it at this price? Assume that the customers will treat the computer with care.
- (3 points) Adverse Selection
A common complaint is that a new car will depreciate by 25% as soon as the new owner drives it off the lot. This information comes from resale price data from cars sold just months after the initial purchase. How does adverse selection imply that most cars depreciate much less?
- (3 points) Adverse Selection and Moral Hazard
George runs a coffee shop in downtown Laredo. He mainly sells his coffee to workers in the surrounding office. He sells cups of coffee for $4 per cup. He works out that his average customer buys 10 cups of coffee per week. He decides to offer his customers the chance to buy a weekly unlimited coffee card that allows them to get as may cups as they want for $40 per week. He hopes that his will speed up his operations because he will not have to run his customers credit cards for every transaction. He will continue to sell cups for $4 to customers who want to buy a single cup. Explain how both moral hazard and adverse selection might undermine the profitability of this scheme.