How signals can be used to solve adverse selection problems.

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Adverse Selection: One party cannot observe certain characteristics of the informed party, and as a result a disproportionate share of people with less desirable characteristics enter the market. For example, if I offer bike insurance, I cannot observe which individuals are more or less likely to ruin their bikes, as a result I will get a disproportionate share of high risk insurers.

Provide a unique and personal example of adverse selection and discuss the possible signals that could be used to identify low and high quality types. Which signal would be most effective and why?

2. In class we have discussed extensively the notion of moral hazard.

Moral Hazard: One party cannot observe the behavior of the informed party, and as a result the informed party will be more likely to act in a way that harms the uniformed party. For example, if I offer bike insurance, I cannot observe how people will behave one they buy my insurance. They are likely to behave in more risky (and hence costly) ways.

You may have heard of the economic problem of “free riding.”

How can moral hazard be thought of as a type of free riding?

Please explain fully and provide an example to illustrate your answer.

Sample Solution

How signals can be used to solve adverse selection problems

Adverse selection refers generally to a situation in which sellers have information that buyers do not have, or vice versa, about some aspect of product quality. In other words, it is a case where asymmetric information is exploited. Asymmetric information, also called information failure, happens when one party to a transaction has greater material knowledge than the other party. Adverse selection in the insurance industry involves an applicant gaining insurance at a cost that is below their true level of risk. Someone with a nicotine dependency getting insurance at the same rate of someone without nicotine dependency is an example of insurance adverse selection.

administration style they best see fit for the present circumstance. Positional power can’t be estimated or measured, making it exceptionally equivocal and difficult for a pioneer to comprehend whether they have it or how then can acquire it. It turns into the obligation of the association to have strategies set up to furnish pioneers with some positional power, ordinarily by laying out an unmistakable hierarchal design. By laying out a progressive system, the pioneer is seen by the gathering to have the option to set expectations and expect consistence from them giving the pioneer authentic power (French and Raven, 1959). Also, by giving the pioneer the capacity to remunerate consistence and rebuff rebelliousness from the gathering, the pioneer has reward and coercive power (French and Raven, 1959). To acquire total control over the gathering the pioneer should acquire the trust and conviction of the gathering that they are fit for progress, by guaranteeing the gathering are both fulfilled and meeting execution objectives. The significance of laying out an order became clear during the arranging phase of the outside administration course for the red group, the organizers inside the group expected influential positions yet couldn’t acquire positional power because of the group being a companion bunch (Pettinger, 2007). The pioneers chose had little power and impact over the gathering as everybody was seen to have similar position, status and occupation, thus the pioneers had none of French and Ravens five bases of force (Pettinger, 2007). The outcome was pioneers with no positional control over the gathering, so couldn’t immediate the gathering with the technique for administration expected for the present circumstance. The undertaking had critical requirements, especially a brief period of time and an enormous gathering size, for the present circumstance Chelladurai suggests a totalitarian initiative style would be generally good (Chelladurai and Madella, 2006). The pioneers endeavored a dictatorial administration style, setting individual assignments for the gathering, but because of the unfortunate chief part relations and absence of positional power the authority structure immediately turned into a majority rules system. The item was a very inefficient labor force at first due to the time spent examining how wa

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