Seminars:
Autumn seminar 1:
Quick summary of asymmetric information types:
Adverse selection – hidden information occurs before the transaction has taken place and
behaviour cannot be monitored.
Moral Hazard – hidden action occurs after the transaction has taken place and behaviour may be
monitored.
Ex post State Verification – the final outcome can only be verified at a cost. It occurs after the
transaction has taken place.
1) Explain why dating can be considered a method to solve the adverse selection problem.
After a couple dates, couples are (explicitly or implicitly) extracting information about the significant
other. At the same time, they are sharing information about themselves. This information flow helps
both individuals to make better decisions about a probable (or not) future life together. In this way,
one can think that this process is formally no different from the one in which the loan officer tries to
choose the right borrower.
2) Suppose you are applying for a mortgage loan. The loan officer tells you that if you get the loan,
the bank will keep the house title until you pay back the loan. Which problem of asymmetric
information is the bank trying to solve?
The bank is trying to solve the moral hazard problem by placing a lien on the house title. In general,
the bank does not “keep the house title”, but it places a lien on it instead to prevent the house
owner from selling the house without its supervision. In this case, the bank wants to make sure that
you do not sell the house, get the money, and never pay back the loan.
3) Give at least three examples of a situation in which financial markets allow consumers to better
time their purchases.
Examples of how financial markets allow consumers to better time their purchases include:
The purchase of a durable good, like a car or furniture.
Paying for tuition.
Paying the cost of repairing a flooded basement.
In all three cases, consumers were able to pay for a good or service (education or the reparation of a
flooded basement) without having to wait to save enough and only then being able to afford such
goods and services.
4) Financial regulation is similar, but not exactly the same, in industrialised countries. Discuss why
it might be desirable—or undesirable—to have the same financial regulation across industrialised
countries.
This is a topic for which there is no clear answer. On one side, it would be beneficial to have financial
regulations that are identical in all countries to avoid financial markets participants to migrate their
business to countries with fewer regulations. On the other side, all countries are different and
designing a common set of financial regulations seems to be a rather difficult task. Most countries
would want to maintain at least part of their regulations, so consensus is difficult to reach.
,5) In December 2001, Argentina announced it would not honour its sovereign (government-issued)
debt. Many investors were left holding Argentinean bonds priced at a fraction of their previous
value. A few years later, Argentina announced it would pay back 25% of the face value of its debt.
Comment on the effects of information asymmetries on government bond markets.
Do you think investors would be willing to buy bonds issued by the government of Argentina after
this announcement?
Information asymmetries are also present in government bond markets. Usually, investors resort to
many information sources about the characteristics of governments to assess their ability or
willingness to honour their debt. As the Argentinean case illustrates, sometimes this lack of
information results in huge losses for bondholders.
In this respect, the problem is not significantly different from an investor who decides which
corporate bond to buy, although it may be fair to say that information about corporate bonds is more
standardized (making it easier to compare firms). After the Argentinean default, investors were
willing to buy bonds issued by its government only at a significant risk premium, making it very costly
for Argentina to raise funds in bond markets.
For questions 6 and 7, use the fact that the expected value of an event is a probability weighted
average, the sum of each possible outcome multiplied by the probability of the event occurring.
6) You wish to hire Ron to manage your company’s North Yorkshire operations. The profits from
the operations depend partially on how hard Ron works, as follows.
If Ron is lazy, he will surf the Internet all day, and he views this as a zero-cost opportunity.
However, Ron views working hard as a “personal cost” valued at £2,000 . What fixed percentage of
the profits should you offer Ron? Assume Ron cares only about his expected payment less any
“personal cost.”
Let P be the percent of profits you pay Ron. If Ron is lazy, his expected payment is:
0.70 × 20,000P + 0.30 × 40,000P = 26,000P
If Ron works hard, his expected payment is:
0.30 × 20,000P + 0.70 × 40,000P – 2,000 = 34,000P – 2,000
To induce Ron to work hard, you need at least:
34,000P – 2000 = 26,000P (set both lazy and hard worker equal to each other)
8,000P = 2,000
P= 0.25
So, offer Ron at least 25% of the profits, and this should induce him to work hard. This answer
demonstrates an example of how business owners can address moral hazard.
,7) You own a house worth £800,000 that is located on River Ouse bank. If the river floods
moderately, the house will be destroyed. This happens about once every 50 years (1/50 = 0.02). If
you build a seawall, the river will have to flood heavily to destroy your house, which only happens
about once every 200 years (1/200 = 0.005).
a) What would be the annual premium for a flood insurance policy that offers full insurance?
b) For a policy that pays only 70% of the home value, what are your expected costs with and
without a seawall?
c) Which policy would you choose?
a) With full insurance:
Without a seawall, the expected loss is:
800,000 × 0.02 = 16,000
With a seawall, the expected loss is:
800,000 × 0.005 = 4,000
The insurance company will charge the expected loss as a premium. Your expected cost under either
scenario each year is the premium - £16,000 without a seawall and £4,000 with a seawall.
b) With partial insurance:
Without a seawall the expected loss is:
(800,000 × 0.70) × 0.02 = 11,200
With a seawall, the expected loss is:
(800,000 × 0.70) × 0.005 = 2,800
c) The insurance company will charge the expected loss as a premium. Your expected cost each year
is:
Without a seawall:
Expected loss + prob of no flood – insurance premium
[Prob of house falling without a seawall × (policy pays 70% of home value – initial house value) +
prob of no flood × loss of no flood without a seawall] – insurance paid for 70% premium without a
seawall.
Prob of no flood = (1 – prob of flood without a seawall) = (1 – 1/50) = 0.98
[0.02 × (560,000 – 800,000) + 0.98(0)] – 11,200 = – 16,000
With a seawall:
Expected loss + prob of no flood – insurance premium
[Prob of house falling with a seawall × (policy pays 70% of home value – initial house value) + prob of
no flood × loss of no flood with seawall] – insurance paid for 70% premium with a seawall.
[0.005 × (560,000 – 800,000) + 0.995(0)] – 2,800 = – 4,000
Prob of no flood = (1 – prob of flood with a seawall) = (1 – 1/200) = 0.995
Neither insurance policy is better nor worse. Although the premiums under the partial insurance
policy are lower, the expected cost each year is the same as with full insurance.
, Seminar 2:
1) A public utility company UCo provides essential water and sewage services to a population of
5,000 households. These comprise households made up of between 1 to 5 persons with 1000 of
each type and are indexed by size. The market is contestable but companies cannot discriminate by
household size. Each person consumes a fixed amount of 50 litres of water a day with an annual
cost to the company of £50. Sewage services cost the same amount per head.
Note: This question demonstrates another example of a market where there is information
asymmetries and adverse selection. Initially, the fact that UCo cannot discriminate by household size
implies it cannot charge a different tariff to each household according to their actual consumption,
but needs to charge a fixed tariff to all households.
a) What does UCo need to charge as a fixed tariff? Is this fair? (Hint: the fixed tariff needs to cover
the average household's cost for both services.)
Average household size =
[ ( 1+ 2+ 3+4 +5 ) × 1,000 ] =3
5,000
Cost per person = cost for water + cost for sewage
= £50 + £50 = £100
Average household of 3 persons costs the company: 3 × £ 100=£ 300
This means that UCO has to charge a fixed tariff of £300. This is a simple example of a pooling
equilibrium, where the small families subsidise the larger ones.
This is not fair because a 2-person household will only cost the company 2 × £ 100=£ 200 but they
still pay a fixed tariff of £300. A 1-person household would only cost the firm £100 but still pay £300.
b) A water meter becomes available which measures the average daily consumption (ADC) of any
household. Suppose that because the market is contestable UCo has to offer customers the option
of metered water at the marginal cost of £1 per litre of ADC plus a lump sum of £150 for sewage
services. Suppose they still have the fixed tariff option at (a). Types that are indifferent remain on
the fixed tariff due to inertia. Is this fair now? What happens to UCo’s annual sales revenue and
profit?
The table below shows the total cost for each type of household for metered tariff:
Type 1 2 3 4 5
Lump Sum (sewage) £150 £150 £150 £150 £150
Water costs £50 £100 £150 £200 £250
Total £200 £250 £300 £350 £400
Remember, the fixed tariff option cost £300 per household.
Type 1 and 2 households find the metered option cheaper and take it up. Types 3’s are indifferent
and stay on the fixed tariff. This is fair to the type 1,2 and 3's who pay for what they get but adverse
selection leaves a high-cost clientele on the fixed tariff.
Company revenue and profit:
UCo breaks even on types 1,2 and 3.
Autumn seminar 1:
Quick summary of asymmetric information types:
Adverse selection – hidden information occurs before the transaction has taken place and
behaviour cannot be monitored.
Moral Hazard – hidden action occurs after the transaction has taken place and behaviour may be
monitored.
Ex post State Verification – the final outcome can only be verified at a cost. It occurs after the
transaction has taken place.
1) Explain why dating can be considered a method to solve the adverse selection problem.
After a couple dates, couples are (explicitly or implicitly) extracting information about the significant
other. At the same time, they are sharing information about themselves. This information flow helps
both individuals to make better decisions about a probable (or not) future life together. In this way,
one can think that this process is formally no different from the one in which the loan officer tries to
choose the right borrower.
2) Suppose you are applying for a mortgage loan. The loan officer tells you that if you get the loan,
the bank will keep the house title until you pay back the loan. Which problem of asymmetric
information is the bank trying to solve?
The bank is trying to solve the moral hazard problem by placing a lien on the house title. In general,
the bank does not “keep the house title”, but it places a lien on it instead to prevent the house
owner from selling the house without its supervision. In this case, the bank wants to make sure that
you do not sell the house, get the money, and never pay back the loan.
3) Give at least three examples of a situation in which financial markets allow consumers to better
time their purchases.
Examples of how financial markets allow consumers to better time their purchases include:
The purchase of a durable good, like a car or furniture.
Paying for tuition.
Paying the cost of repairing a flooded basement.
In all three cases, consumers were able to pay for a good or service (education or the reparation of a
flooded basement) without having to wait to save enough and only then being able to afford such
goods and services.
4) Financial regulation is similar, but not exactly the same, in industrialised countries. Discuss why
it might be desirable—or undesirable—to have the same financial regulation across industrialised
countries.
This is a topic for which there is no clear answer. On one side, it would be beneficial to have financial
regulations that are identical in all countries to avoid financial markets participants to migrate their
business to countries with fewer regulations. On the other side, all countries are different and
designing a common set of financial regulations seems to be a rather difficult task. Most countries
would want to maintain at least part of their regulations, so consensus is difficult to reach.
,5) In December 2001, Argentina announced it would not honour its sovereign (government-issued)
debt. Many investors were left holding Argentinean bonds priced at a fraction of their previous
value. A few years later, Argentina announced it would pay back 25% of the face value of its debt.
Comment on the effects of information asymmetries on government bond markets.
Do you think investors would be willing to buy bonds issued by the government of Argentina after
this announcement?
Information asymmetries are also present in government bond markets. Usually, investors resort to
many information sources about the characteristics of governments to assess their ability or
willingness to honour their debt. As the Argentinean case illustrates, sometimes this lack of
information results in huge losses for bondholders.
In this respect, the problem is not significantly different from an investor who decides which
corporate bond to buy, although it may be fair to say that information about corporate bonds is more
standardized (making it easier to compare firms). After the Argentinean default, investors were
willing to buy bonds issued by its government only at a significant risk premium, making it very costly
for Argentina to raise funds in bond markets.
For questions 6 and 7, use the fact that the expected value of an event is a probability weighted
average, the sum of each possible outcome multiplied by the probability of the event occurring.
6) You wish to hire Ron to manage your company’s North Yorkshire operations. The profits from
the operations depend partially on how hard Ron works, as follows.
If Ron is lazy, he will surf the Internet all day, and he views this as a zero-cost opportunity.
However, Ron views working hard as a “personal cost” valued at £2,000 . What fixed percentage of
the profits should you offer Ron? Assume Ron cares only about his expected payment less any
“personal cost.”
Let P be the percent of profits you pay Ron. If Ron is lazy, his expected payment is:
0.70 × 20,000P + 0.30 × 40,000P = 26,000P
If Ron works hard, his expected payment is:
0.30 × 20,000P + 0.70 × 40,000P – 2,000 = 34,000P – 2,000
To induce Ron to work hard, you need at least:
34,000P – 2000 = 26,000P (set both lazy and hard worker equal to each other)
8,000P = 2,000
P= 0.25
So, offer Ron at least 25% of the profits, and this should induce him to work hard. This answer
demonstrates an example of how business owners can address moral hazard.
,7) You own a house worth £800,000 that is located on River Ouse bank. If the river floods
moderately, the house will be destroyed. This happens about once every 50 years (1/50 = 0.02). If
you build a seawall, the river will have to flood heavily to destroy your house, which only happens
about once every 200 years (1/200 = 0.005).
a) What would be the annual premium for a flood insurance policy that offers full insurance?
b) For a policy that pays only 70% of the home value, what are your expected costs with and
without a seawall?
c) Which policy would you choose?
a) With full insurance:
Without a seawall, the expected loss is:
800,000 × 0.02 = 16,000
With a seawall, the expected loss is:
800,000 × 0.005 = 4,000
The insurance company will charge the expected loss as a premium. Your expected cost under either
scenario each year is the premium - £16,000 without a seawall and £4,000 with a seawall.
b) With partial insurance:
Without a seawall the expected loss is:
(800,000 × 0.70) × 0.02 = 11,200
With a seawall, the expected loss is:
(800,000 × 0.70) × 0.005 = 2,800
c) The insurance company will charge the expected loss as a premium. Your expected cost each year
is:
Without a seawall:
Expected loss + prob of no flood – insurance premium
[Prob of house falling without a seawall × (policy pays 70% of home value – initial house value) +
prob of no flood × loss of no flood without a seawall] – insurance paid for 70% premium without a
seawall.
Prob of no flood = (1 – prob of flood without a seawall) = (1 – 1/50) = 0.98
[0.02 × (560,000 – 800,000) + 0.98(0)] – 11,200 = – 16,000
With a seawall:
Expected loss + prob of no flood – insurance premium
[Prob of house falling with a seawall × (policy pays 70% of home value – initial house value) + prob of
no flood × loss of no flood with seawall] – insurance paid for 70% premium with a seawall.
[0.005 × (560,000 – 800,000) + 0.995(0)] – 2,800 = – 4,000
Prob of no flood = (1 – prob of flood with a seawall) = (1 – 1/200) = 0.995
Neither insurance policy is better nor worse. Although the premiums under the partial insurance
policy are lower, the expected cost each year is the same as with full insurance.
, Seminar 2:
1) A public utility company UCo provides essential water and sewage services to a population of
5,000 households. These comprise households made up of between 1 to 5 persons with 1000 of
each type and are indexed by size. The market is contestable but companies cannot discriminate by
household size. Each person consumes a fixed amount of 50 litres of water a day with an annual
cost to the company of £50. Sewage services cost the same amount per head.
Note: This question demonstrates another example of a market where there is information
asymmetries and adverse selection. Initially, the fact that UCo cannot discriminate by household size
implies it cannot charge a different tariff to each household according to their actual consumption,
but needs to charge a fixed tariff to all households.
a) What does UCo need to charge as a fixed tariff? Is this fair? (Hint: the fixed tariff needs to cover
the average household's cost for both services.)
Average household size =
[ ( 1+ 2+ 3+4 +5 ) × 1,000 ] =3
5,000
Cost per person = cost for water + cost for sewage
= £50 + £50 = £100
Average household of 3 persons costs the company: 3 × £ 100=£ 300
This means that UCO has to charge a fixed tariff of £300. This is a simple example of a pooling
equilibrium, where the small families subsidise the larger ones.
This is not fair because a 2-person household will only cost the company 2 × £ 100=£ 200 but they
still pay a fixed tariff of £300. A 1-person household would only cost the firm £100 but still pay £300.
b) A water meter becomes available which measures the average daily consumption (ADC) of any
household. Suppose that because the market is contestable UCo has to offer customers the option
of metered water at the marginal cost of £1 per litre of ADC plus a lump sum of £150 for sewage
services. Suppose they still have the fixed tariff option at (a). Types that are indifferent remain on
the fixed tariff due to inertia. Is this fair now? What happens to UCo’s annual sales revenue and
profit?
The table below shows the total cost for each type of household for metered tariff:
Type 1 2 3 4 5
Lump Sum (sewage) £150 £150 £150 £150 £150
Water costs £50 £100 £150 £200 £250
Total £200 £250 £300 £350 £400
Remember, the fixed tariff option cost £300 per household.
Type 1 and 2 households find the metered option cheaper and take it up. Types 3’s are indifferent
and stay on the fixed tariff. This is fair to the type 1,2 and 3's who pay for what they get but adverse
selection leaves a high-cost clientele on the fixed tariff.
Company revenue and profit:
UCo breaks even on types 1,2 and 3.
