Question

1. If the interest rate is 7% and an asset pays 100 per year for 5 years, starting now, show the present value of the income stream (to 2 decimal places) is $438.72.

2. What is adverse selection?

3. Give an example of adverse selection.

4. What is moral hazard?

5. Give an example of moral hazard.

6. What are the assumptions/conditions of perfectly competitive capital markets? We assumed 2 periods but in practice people also assume other numbers, it is not critically important the exact number if there is more than 1 period.

7. Use the two period model of utility maximization (we will always assume perfectly competitve capital markets in this model) to show the impact on a borrower if the market interest rate increases. Hint: they are worse off.

8. Consider a world with two goods, X and Y. Please label all diagrams fully. a. Using an indifference curve diagram(s) derive the demand curve for X if the goods are: i. Complements ii. Substitutes b. Discuss the similarities and differences between the demand curves for the two cases in part (a).

9. Explain and discuss, using a diagram, the effect of a minimum wage above the market/equilibrium wage in a monopsony. Please label all diagrams fully.

Answer 1

1.

It is a case of annuity due as income starts from now.

Present value = (100*(1-1/1.07^5)/.07)*1.07

Present value = $438.72

2.

Adverse selection is a type of market failure when there is an asymmetry of information between the buyers and sellers. It causes, one party to gain undue advantage due to lack of knowledge held by the other party.

3.

Example of adverse selection is as follows:

A seller of the used car knows more about the car, in terms of the its function, deficiencies, problems created by the car, than the potential buyer who is willing to buy the car. It creates information asymmetry between the buyers and sellers. As a result, adverse selection is created.

4.

Moral hazard is a phenomenon where the outcome of the action taken by one party is to be taken by the other parties. Or, one party takes action, but risk or loss is taken up by the other parties. It is also a type of market failure.

5.

Directions in the bank make speculative investments, knowing that the losses if incurred, will be faced by the investors and depositors of the banks and they as a director will not face any personal losses.

Pl. repost other unanswered questions for their proper answers!