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Classify each of the following as examples of Moral Hazard

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1. Classify each of the following as examples of Moral Hazard, Adverse Selection or Neither. Explain your answer and note one way to alleviate the problem. a) A board of directors oversees the operations of a company and its management. b) Stock holders may not get the optimal amount of dividends because profits are reinvested in the company in order to maximize the CEO’s influence. c) The principle‐agent problem d) The lemons problem e) Some people claim that: A free democracy in Iraq could encourage emmigration of freedom seeking Iranian students from Iran to Iraq thus reducing the pressure on the Iranian government to reform. f) Some people claim that: A functioning democracy in Iraq will cause the Iranian government to tighten restrictions on its population, making democracy in Iran less likely to occur peacefully. g) A depressed individual might buy life insurance before committing suicide. 2. Is the lemons problem more severe for bonds issued by democratic governments or dictatorships? Explain. 3. Which of the following are attempts to solve an asymmetric information problem? Explain. a) Auditing firms (hired by the board of directors and approved by the shareholders) b) Stock broker’s commissions c) Private Production and sale of information d) Financial intermediation e) Collateral 4. Rich people often worry that others will seek to marry them only for their money. Is this a problem of adverse selection? Explain. 5.This game takes place in a market for used cars. Sellers are selling a 2005 Ford Freebird. They could be worth anything from $6.000 to $10,000 depending on the quality of the car. All cars look the same to the buyer, despite the quality differences. No dents, no sputtering, they all feel fine, but some have been well maintained and be worth the top of that price range while others were neglected and nobody should pay above the bottom of that range, while others will be at various points in between. The buyers’ problem is that they have no way of telling the underlying quality of the cars. The cars are worth $6,000, $7,000, $8,000, $9,000 or $10,000, each with equal (20%) probability. On the other hand, the sellers know the true value of the car. If you are a seller of a car worth $7,000 what prices should you be willing to accept? _________ If you are a buyer, what should you be willing to pay for the car. What is the expected value of the car? If you buy a car for any more than the expected value you are likely to get a bad deal? ____________________________________________________________________________ The following information was given to the people in class: You have a 2005 Ford Freebird which you think you might like to sell it. You know that it has a few glitches but is generally a very good car. You know that it is worth $9,000. You will accept nothing less. And You would like to buy a 2005 Ford Freebird. They could be worth anything from $6.000 to $10,000 depending on the quality of the car. You can find several but they all look the same to you. No dents, no sputtering, they all feel fine, but you know that some have been well maintained and be worth the top of that price range while others were neglected and you should not pay above the bottom of that range, while others will be at various points in between. Your problem is that you have no way of telling the underlying quality of the cars. When you see a car it could be worth $6,000, $7,000, $8,000, $9,000 or $10,000, each with equal (20%) probability. What should you be willing to pay for the car. What is the expected value of the car? If you buy a car for any more than the expected value you are likely to get a bad deal.

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