Week 11 - Choice under risk and uncertainty, Asymmetric information, International trade Flashcards

Question

When information is asymmetric in terms of low ability and high ability workers

Answer 1

In reality, asymmetric information is often present in the labor market. The employer does not know the worker’s ability in advance, so they must make decisions based on the information available. Here's how the situation might unfold: The Employer’s Dilemma: The employer cannot directly observe whether a worker is of low ability or high ability. This creates uncertainty about the value the worker will bring to the company. As a result, the employer may face the challenge of offering a wage that is attractive enough for both high and low ability workers, but also fairly compensates the worker's productivity. The Adverse Selection Problem: If the employer offers a wage that is somewhere between £200 and £400, workers with higher ability (who have a higher MRP) may be reluctant to accept the wage if it is too low for their skills, while low ability workers might be willing to accept that wage. High ability workers, knowing their higher value to the company, might expect to be paid more than £200, but they may not reveal their ability up front, and so they might not be interested in a wage offer of £200. In turn, low ability workers might accept a wage that is close to the £200 level, because they have lower productivity and thus a lower expectation of wages. This problem is known as adverse selection: the employer may end up hiring more low ability workers than high ability ones if they cannot differentiate between them. Potential Solutions to Asymmetric Information: Screening: Employers may use techniques such as interviews, testing, or probation periods to better understand the worker's skills and abilities. Signaling: Workers may provide signals of their ability through education, experience, or other credentials to differentiate themselves from lower ability workers. Wage Differentiation: The employer could offer higher wages to incentivize higher ability workers to self-select themselves for the position, though this could also attract low ability workers if the wage is too attractive.

Answer 2

refers to a situation in a market where one party (usually the seller or employer) has less information than the other party (usually the buyer or employee), leading to the selection of undesirable outcomes. This typically happens when the party with more information makes decisions that result in a market inefficiency. In simple terms, adverse selection occurs when individuals with higher risks or lower quality (for example, less skilled workers or riskier insurance buyers) are more likely to participate in a transaction because the other party cannot distinguish them from others who might be of better quality.

Answer 3

Let’s assume that the employer offers a wage of £300 per week in an attempt to balance between the two types of workers: Low Ability Worker’s Response: The low ability worker, who has a marginal revenue product of £200 per week, is likely to accept the £300 wage because it’s more than their MRP and represents an improvement in their compensation. High Ability Worker’s Response: The high ability worker, who has a marginal revenue product of £400 per week, may not accept the £300 wage because it is below their MRP, and they could likely find a better-paying opportunity elsewhere. Therefore, the employer may end up attracting more low ability workers than high ability workers, resulting in inefficient labor allocation (the company might hire workers who are underpaid relative to their ability, while underutilising high ability workers).

Answer 4

The Market for Lemons model, developed by George Akerlof in 1970, demonstrates how asymmetric information can lead to market failure. It describes a situation where buyers and sellers have unequal information about the quality of goods, leading to a reduction in the overall quality of goods available in the market.

Answer 5

Lemons refer to low-quality goods that are more likely to be sold by sellers who are trying to unload them at a price. The term "lemons" was used by Akerlof to describe the bad cars that sellers were more eager to sell, often due to hidden defects or lower value.

Answer 6

In a used car market, the sellers have more information about the condition of the car than the buyers. Buyers cannot distinguish between good cars (high-quality) and bad cars (lemons, low-quality).

Answer 7

Buyers are aware of the risk that they might purchase a lemon, so they lower their reservation price (the maximum price they are willing to pay). Skepticism leads to price reduction because the buyers cannot tell whether a car is a lemon or a good one, so they adjust their expectations.

Answer 8

Sellers of high-quality cars (those with "good cars") know that they cannot get the price they want because of the lower average price in the market caused by the presence of lemons. Good car owners may decide to keep their cars instead of selling them for a lower price, reducing the number of good cars available on the market.

Answer 9

As more and more lemons (bad cars) are sold, the overall quality of the goods in the market declines. Buyers' confidence drops, and they continue to offer even lower prices for used cars. Eventually, this reduces the supply of high-quality cars (as people with good cars withdraw from the market), which can lead to a collapse of the market for used cars—leading to a market failure.

Answer 10

1. sellers know more (know how used their car is) 2. buyers lower their price (uncertain about quality) 3. good car sellers leave the market (if the price buyers are willing to pay is too low) 4. more lemons on the market (buyers adjust their prices even further downward) 5. market collapses (the average quality of cars on the market continues to decline, and the market may fail altogether)

Answer 11

Assume there are only good cars and lemons, 10% of all cars are lemons. Good used cars worth £10,000, lemons £6,000 The used car market is 90% good cars and 10% lemons Calculating expected value 0.9 x £10,000 + 0.1 x £6000 = £9600 This is the reservation price for a risk neutral buyer

Answer 12

People take fewer precautions when they know they are insured

Answer 13

1. A driver in possession of a car insurance policy may exercise less care while operating their vehicle than an individual with no car insurance. 2. Governments promising to bail out loss-making banks can encourage banks to take greater risks. 3. When a business owner pays a salesperson a set salary–not based on their performance or sales numbers– that salesperson may have an incentive to put forth less effort.

Answer 14

refers to the value of the next best alternative that must be forgone in order to pursue a particular action

Answer 15

His opportunity cost for doing it himself is the lost wages for four hours, £800

Answer 16

refers to the ability of an individual, firm, or country to produce a good or service more efficiently than others. Specifically, it means that the entity can produce the same quantity of a good with fewer resources or produce more of a good using the same amount of resources than its competitors

Answer 17

a graph that describes the maximum amount of one good that can be produced for every possible level of production of the other good illustrates the trade-offs between the two goods, meaning that producing more of one good typically requires producing less of the other good, due to scarcity of resources

Answer 18

The slope of the PPC represents the opportunity cost of producing one good in terms of the other. As you move along the curve, to produce more of one good, you have to give up some amount of the other good The PPC shows the trade-off between two goods or services. If an economy is producing at a certain point on the curve, to produce more of one good, it must sacrifice some amount of the other

Answer 19

The PPC highlights the scarcity of resources (land, labor, capital, and entrepreneurship). Since resources are limited, we cannot produce unlimited quantities of every good or service, and we must make choices about how to allocate resources

Answer 20

Points on the curve represent efficient production, where all resources are used fully and efficiently. Points inside the curve represent inefficiency (i.e., not using resources fully or efficiently). Points outside the curve are unattainable with the current resources and technology Two attainable points are the inefficient and efficient points

Answer 21

describing how two parties (individuals, firms, or countries) can benefit from specialising in the production of goods for which they have the lowest opportunity cost and then trading with one another

Answer 22

Opportunity cost of good X = Amount of good Y given up/ amount of good x produced

Answer 23

Zoe: 8 Bread = 6 Beer 1 Bread = 6/8 Beer 1 Bread = 0.75 Beer 6 Beer = 8 Bread 1 Beer = 8/6 Bread 1 Beer = 1.33 Bread Ian: 5 Bread = 4 Beer 1 Bread = 4/5 Beer 1 Bread = 0.8 Beer 4 Beer = 5 Bread 1 Beer = 5/4 Bread 1 Beer = 1.25 Bread Zoe has a comparative advantage over Ian in the production of Bread. Ian has a comparative advantage over Zoe in the production of Beer

Answer 24

Countries can specialise in producing goods and services for which they have a comparative advantage (i.e., the lowest opportunity cost). This specialisation leads to more efficient production processes, as each country focuses on what it does best. Resources are used more efficiently, as countries allocate labor and capital toward industries where they have a productivity edge, leading to higher output and lower costs (resource allocation)

Answer 25

To benefit both people, the price of bread needs to be between 0.75 Beer and 0.8 Beer 0.75 beer ≤ 1 bread ≤ 0.8 beer 1.25 bread ≤ 1 beer ≤ 1.33 bread Suppose a trade price (of bread) is determined so that 1 bread = 0.78 beer (1 beer = 1.282 bread) If trade: Before trade: Zoe has 8 units of bread. If Zoe sells 3.9 units of bread to Ian then Zoe will get 0.78 * 3.9 = 3.042 units of beer After trade: Zoe has 4.1 bread + 3.042 beer If trade: Before trade: Ian has 4 units of beer. If Ian sells 1.99 units of beer to Zoe then Ian will get 1.282 * 1.99 = 2.55 units of bread After trade: Ian has 2.55 bread + 2.01 beer Both better off, international trade on the basis of comparative advantage improves global output. If no trade: Zoe has 4 bread + 3 beer (spend 30 minutes on producing each good) If no trade: Ian has 2.5 bread+ 2 beer (spend 30 minutes on producing each good)

Answer 26

A tariff (tax on imports) makes foreign goods more expensive, which typically reduces the volume of imports. The extent of this reduction depends on how sensitive demand is to price changes (i.e., the price elasticity of demand for the goods) Like (many) other taxes, they distort the operation of the market and so lead to a welfare loss

Answer 27

Other countries may retaliate by imposing tariffs on the country's exports, which could hurt the exporting industries. This trade war dynamic can harm both the exporting and importing country, leading to reduced global trade and further welfare losses

Week 11 - Choice under risk and uncertainty, Asymmetric information, International trade Flashcards

(53 cards)