Question

For Questions 4 and 5, use the list of reasons provided below:

List of Reasons for Intervention

Risk Aversion and Risk Trading

Monopoly Power or Market Power

Negative Externality

Positive Externality

Public Good

Asymmetric Information/Adverse Selection

Moral Hazard or Hidden Action.

4. Some insurance companies require individuals to take a blood test before qualifying for lower health insurance premiums. a.Identify the problem that insurance companies are trying to address. Choose from list above. (1 point) b. Briefly explain how the proposed solution remedies the inefficiency. (2 points)
5. Many employment contracts offer their employees stock options in the company as part of their compensation. a. Identify the problem that employers are trying to address with this compensation. Choose from list above. (1 point) b.Briefly explain how the proposed solution remedies the inefficiency. (2 points)

Answer 1

1) Some insurance companies require individuals to take a blood test before qualifying for lower health insurance premiums.

1.a) Asymmetric information is the phenomenon where one party has more information than the other party involved in a transaction. There is asymmetric information between the individual buying the health insurance in the sense that the individual buying the health insurance has more information about his own health than the company selling it. For a company salesmen, the individual may seem to be healthy, but in reality he may be not so healthy. This is a case of Asymmetric Information/Adverse Selection.

1.b) The proposed solution (blood test) acts a mechanism of gaining knowledge about the individual's health. By conducting the blood test, company might know some facts about the health of the individual which they did not know before and therefore, with more information can decide whether to offer the insurance or how much to charge. It acts as a mechanism to reduce asymmetric information.

2) Many employment contracts offer their employees stock options in the company as part of their compensation.

2.a) Moral hazard occurs when one party changes its behaviour after the transaction has been concluded because of the fact that he is protected from the risk. In this case the employer does not know whether the employee is hardworking or a lazy person. After the employee is hired (transaction took place), he may not work at his full potential knowing the fact that he will still his monthly compensation (assuming stocks are not a part) even if he does not work to his full potential. If he works less, the loss would have to be borne by the employer. Therefore, this is a case of moral hazard.

2.b) If the employer includes stock options in the company as part of employee's compensation, this would induce employees to work harder. The employee would know that if he works at this full potential, the company would grow and as the company grows, its stock will be more valued. Thereby, the compensation of that employee would increase in value. In this way, employer ensures that the employee is incentivize to work at his full potential and moral hazard is reduced.