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ECO204: Solutions to Homework 5 1. True, False, Uncertain a. False. Methods to eliminating moral hazard include writing efficient contracts between principals and agents, bonding and deferred payments. The methods to eliminate adverse selection include sending signals and relying on 3rd parties to verify quality. b. True. When there is asymmetric information, it drives out high-quality goods because consumers have a difficult time differentiating between high- and low-quality goods. As a result, they are only willing to make an offer equal to the expected value, which is lower than the value of the high-quality good. This drives out sellers of high-quality goods, so that only low quality goods are sold. When there are only low quality goods in the market, the price that is offered (the EV) is higher than the value of the product or its marginal cost (allowing sellers of low-quality goods to make a profit). c. False. Principals will write contracts for their agents to prevent moral hazard, not adverse selection. d. False. For contracts to be efficient, they must not only discourage moral hazard (the opportunity to lie/cheat the principal), but also encourage efficiency in production (the agent should produce the optimal units of output that max profits) and allocate risk efficiently (the risk-averse individual bears less risk than the risk-neutral individual). e. Uncertain – it depends on the contract. According to the summary table on contracts we filled out (I’ve posted this on Blackboard) there are instances where the individual was originally not efficiently producing goods under perfect information, but later changed their behavior with asymmetric information because there was an opportunity to underreport his/her effort level and profit from the sale of unreported goods (Cases 2a and 3a). For these two cases, the statement is false. Since the sale price of unreported goods is dependent on the equilibrium market price, the worker will switch from being inefficient to being efficient in production when the principal is no longer able to monitor their behavior. However, there are other types of contracts where the statement is true. For example, in cases 1a and 2b, the worker is consistently going to produce an inefficient number of goods (in case 1a, they consistently produce less than the optimal units of output; in 1b, they consistently produce more than the optimal units of output). In cases 1b, 2b and 3b, they consistently produce the optimal units of output. 2. Wages for two types of workers: wL = P × MPLL = $5,000(5) = $25,000 wH = P × MPLH = $5,000(9) = $45,000 But if firms cannot distinguish individuals between low and high productivity, they have to pay workers according to their average product: 0.5(5 + 9) = 7 Wavg = $5,000(7) = $35,000

High productivity workers will not work for $35,000 as an offered wage, so only lowproductivity workers will accept the job. 3. For low productivity workers: costL = 30,000y benefit = $100,000 Firms must set a level of schooling so that cost > benefit: this will cause low productivity workers to not receive an education. 30,000yL > 100,000 yL > 10/3 or 3.33 years For high productivity workers: costH = 20,000yH benefit = $100,000 Firms must set a level of schooling so that the cost < benefit for high ability workers, otherwise high productivity workers won’t receive the education either. The result will be a pooling equilibrium as education won’t serve as a useful signal to differentiate between the two types of workers. 20,000yH < 100,000 yH < 5 So firms should pay workers wH if the number of years of education a worker has completed y* years of education, where y* is: 10/3 < y* < 5 4. As chairman of the board of ASP Industries, you estimate that your annual profit is given by the table below. Profit (P) is conditional upon market demand and the effort of your new CEO. The probabilities of each demand condition occurring are also shown in the table. Market Demand Market...
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