Worksheet 38

2.10 Market Failure – Asymmetric Information & Moral Hazard (HL)

1) Define the term asymmetric information. [2 marks]

When economic decisions are made based on incomplete information, meaning that not all parties involved in a
………………………………………………………………………………………………………………………………
transaction have perfect knowledge or all the information to make the economic decision.
………………………………………………………………………………………………………………………………

2) Define the term moral hazard. [2 marks]

Describes a situation in which one participant taken on more risky behaviour because they don't pay the
………………………………………………………………………………………………………………………………
consequences of that increased risk. The behaviour changes after the transaction took place.
………………………………………………………………………………………………………………………………

3) The following are some examples of moral hazards in action. Outline the role taken by the producer and
consumer in each of the following economic transactions. [6 marks]
Example Producer / service provider Consumer / buyer

A tourist takes a
taxi to go to their
next point of
attraction

A private car
driver signs a
full coverage
motor insurance
policy

Insurance policy Cafe owner

A café owner
signs a fire
insurance policy

The Global financial crisis of 2008

During the 2008 global financial crisis, the “big 4 banks” in the USA - Citigroup, Bank of America Corp., JP
Morgan & Chase Co., and Wells Fargo - were among the largest that were bailed out by the US Government.
Prior to the crisis, these banks were making aggressive loans to consumers on risky mortgages to achieve
greater profits due to the strong economy at the time. The crisis was also partly due to the Federal Reserve’s
relaxed policy over granting emergency loans to financial institutions. Customers were able to obtain these
loans without much difficulty, which fueled the housing market (higher house prices) in America. Ultimately,
the banks had too little liquidity and the delinquency from their borrowers worsened the fall of these large
financial institutions during the crisis.

4) Describe the moral hazard in the above situation. [2 marks]

………………………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………………

5) Identify one party that bears the cost of the actions taken by the big 4 banks above. [1 mark]

………………………………………………………………………………………………………………………………

6) Suggest one way in which the US government could correct this moral hazard. [2 marks]
By limiting the access of the emergency loans to the financial institutions.
………………………………………………………………………………………………………………………………

………………………………………………………………………………………………………………………………

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 Worksheet 39
2.10 Market Failure – Asymmetric Information & Adverse Selection (HL)

1) Define the term adverse selection. [2 marks]

A situation when one participant has more information before the transaction occurs.
………………………………………………………………………………………………………………………………

………………………………………………………………………………………………………………………………

Read the following to help you answer Questions 2 and 3. This is a dialogue between a sales
representative from a life insurance company and Daniel, a regular smoker who plans to buy himself a life
insurance policy.
Sales Daniel, the insurance policy that you are about to sign will cost you USD$100 per
representative: month for the insured term of 30 years. All the terms and conditions are listed on our
website, but essentially this is the standard plan and you will be fully covered.
Daniel: Thank you, this sounds about right!
(In his mind: Thank goodness he did not ask me about my smoking habits! Let me go
and tell my other friends who smoke they can get their life insurance policy here!)

2) Describe how the above situation creates an adverse selection for the life insurance company. [2 marks]
Daniel, the customer, regularly smokes, an unhealthy habit which can be costly in the long run as he's more viable of
………………………………………………………………………………………………………………………………
getting sick. The insurance is unaware of this information. Therefore, the client will continue on doing it as he knows
that the future consequences on his health will be covered.
………………………………………………………………………………………………………………………………

3) Suggest one way in which the life insurance company could consider using to reduce the risk of
adverse selection. [2 marks]
By doing a questionnaire of unhealthy habits that his customers may do so then these are taken into account when the
………………………………………………………………………………………………………………………………
final price is stated to the client as the unhealthier habits, the more expensive the insurance will be.
………………………………………………………………………………………………………………………………

Read the following short extract to answer Questions 4 and 5.

The 2001 Economics Nobel Prize award winner, George Akerlof, is most famous for the article he published
“The Market for Lemons: Quality Uncertainty and the Market Mechanism”. The market for lemons can be
illustrated using the example of the buyer and seller in a second-hand or used car dealership.

4) Using the example above, describe how asymmetric information lead to adverse selection for the used
car buyer. [2 marks]
In this situation, not both parties, the buyer and seller, have complete information about the cars. The seller has
………………………………………………………………………………………………………………………………
more information about the car than the buyers, leading to adverse selection.
………………………………………………………………………………………………………………………………

5) Describe one possible solution to this adverse selection for the buyer of a second-hand car. [2 marks]
The seller of the used car dealership could have a certificate that guarantees the quality of the car so the buyers
………………………………………………………………………………………………………………………………
are certain of what they are buying.
………………………………………………………………………………………………………………………………
Read the following short extract to answer Questions 6 and 7.
Enron Corporation was an American energy company and one of the largest companies on the New York
Stock Exchange (NYSE), with a market valuation of more than $70 billion. However, the company began
suffering from falling profitability and accumulated debt in 1997. As the directors did not want their stock
price to plummet, they manipulated the way earnings were reported, which led to the media speculating
whether or not the company was overvalued. This speculation led to a huge sell-off by investors engaging in
insider trading. Ultimately, Enron’s stock price fell, and the company filed for bankruptcy in December 2001.

6) Explain one way how public investors were affected by the adverse selection. [2 marks]
Public ………………………………………………………………………………………………………………………………
investors were unaware of the debts the company held. Due to this, they continued investing, something

that let………………………………………………………………………………………………………………………………
them to no profitability in their investment as the company was filed for bankruptcy years later.

7) Identify one possible solution the government could use to tackle the adverse selection. [1 mark]
Control better how the earnings of the companies are reported, checking that these are real and not modified.
………………………………………………………………………………………………………………………………
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 Worksheet 40
2.11 Market Structure – Rational Producer Behaviour (1) (HL)
1) Complete the following table by calculating the total revenue (TR), average revenue (AR) and marginal
revenue (MR). [4 marks]

Price Q TR AR MR 3) Plotting the revenue data from Question 1 gives the

($) (units) ($) ($) ($) diagram below. State each of the missing labels as
30 0 0 0 25 indicated in the diagram. [7 marks]

25 5 125 25 15

20 10 200 20 5

15 15 225 15 5

10 20 200 10 15

5 25 125 5 25

0 30 0 0 ---

2) Calculate the PED between the following

price and quantity levels: [2 marks]
Label 1: ………………….. Label 5: …………………..
(a) P = $25 to P = $20 and Q = 5 to 10 units
5/5 = 1=PED Label 2: ………………….. Label 6: …………………..
……………………….………………………….
Label 3: ………………….. Label 7: …………………..
(b) P = $10 to P = $5 and Q = 20 to 25 units
Label 4: …………………..
……………………………………….………….

4) Complete the following table by calculating all of the missing costs. [8 marks]
TFC TVC TC AC AFC AVC MC
Output Total fixed Total variable Total Average Average Average variable Marginal
(Q) cost ($) cost ($) cost ($) cost ($) fixed cost ($) cost ($) cost ($)
0 375 --- 375 --- --- --- 125---
1 375 125 500 500.00 375.00 125.00 125
2 375 240 615 187.5 120.00 115
3 375 340 715 238.33 125.00 113.33
4 375 475 850 212.50 93.75 118.75 135
5 375 700 1,075 215.00 75.00 140
6 375 1,000 1,375 229.17 62.50 166.67 300

5) Plotting the cost data from Question 3 will result in the diagram below. State each of the missing labels
in the diagram and state the point at which MC intersects AC. [5 marks]

Label 1: …………………

Label 2: …………………

Label 3: …………………

Label 4: …………………

MC intersects AC at the:

…………………………….

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