Module M21 Quiz: Information Asymmetry and Synthesis
25 questions Β· Intermediate Β· Multiple choice, calculation, and short answer
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Attempt each question before clicking Show Answer.
Question 1
Lesson L01 Β· Information
Akerlof's market for lemons demonstrates that:
Type: Multiple Choice
- A) Used cars are always low quality
- B) Information asymmetry between buyers and sellers can cause market failure β adverse selection drives out high-quality goods
- C) Government should regulate used car markets
- D) All insurance markets fail
Show Answer
Answer: B) Information asymmetry between buyers and sellers can cause market failure β adverse selection drives out high-quality goods
Akerlof (1970): sellers know quality, buyers don't. Only low-quality cars are sold at any price β adverse selection unravels the market.
Question 2
Lesson L01 Β· Information
In Akerlof's model with quality q uniform on [0,1], seller value=q, buyer value=1.5q and average quality sold at price p = p/2: calculate buyer WTP at price p.
Type: Calculation
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Answer: WTP = 1.5 Γ (p/2) = 0.75p < p
Buyers know average quality of cars offered at price p is p/2 (only sellers with qβ€p sell). Buyer WTP = 1.5Γp/2 = 0.75p. Since 0.75p < p, no trade occurs at any p > 0.
Question 3
Lesson L01 Β· Information
Why does adverse selection in health insurance cause premiums to rise even when the insurer is competitive?
Type: Short Answer
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Answer: High-premium policies attract sicker individuals (adverse selection). As healthy individuals opt out, the remaining pool is sicker, costs rise, premiums must rise further β a vicious cycle. In Australia, Medicare addresses this via universal coverage; private health insurance uses community rating to limit adverse selection.
Adverse selection creates an adverse spiral: rising premiums β worse pool β higher costs β higher premiums.
Question 4
Lesson L01 Β· Information
Which mechanism can reduce adverse selection in used car markets?
Type: Multiple Choice
- A) Price controls
- B) Signalling β sellers of high-quality cars provide credible signals (warranties, inspection certificates) that low-quality sellers cannot profitably mimic
- C) Quantity restrictions
- D) Tax on used cars
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Answer: B) Signalling β sellers of high-quality cars provide credible signals (warranties, inspection certificates) that low-quality sellers cannot profitably mimic
Signals work when they are costly to fake: a warranty on a high-quality car is cheap (low probability of claim) but expensive for a lemon seller (high claim probability) β a credible signal.
Question 5
Lesson L01 Β· Information
Australia's private health insurance 'lifetime health cover' loading (2% per year after age 30) is designed to:
Type: Multiple Choice
- A) Raise revenue for private insurers
- B) Reduce adverse selection by encouraging younger/healthier people to join early rather than waiting until they are sick
- C) Punish older Australians
- D) Subsidise older policyholders
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Answer: B) Reduce adverse selection by encouraging younger/healthier people to join early rather than waiting until they are sick
Lifetime health cover loading reduces adverse selection: joining early when healthy is incentivised, preventing the adverse selection spiral where only sick people buy insurance.
Question 6
Lesson L02 Β· Information
Moral hazard differs from adverse selection because:
Type: Multiple Choice
- A) Both involve information asymmetry at the same stage
- B) Adverse selection is pre-contractual (hidden type); moral hazard is post-contractual (hidden action after the contract is signed)
- C) Moral hazard only affects insurance
- D) Adverse selection only affects labour markets
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Answer: B) Adverse selection is pre-contractual (hidden type); moral hazard is post-contractual (hidden action after the contract is signed)
Adverse selection: hidden information before contracting (who are you?). Moral hazard: hidden action after contracting (what will you do?). Both are information problems.
Question 7
Lesson L02 Β· Information
In a principal-agent model the agent exerts effort e and output is y=e+Ξ΅. The principal maximises E[y]-w(y). The first-best contract requires:
Type: Calculation
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Answer: e* that maximises E[y-c(e)] = e-c(e) where c(e) is cost of effort. FOC: 1=c'(e*) β but principal can't observe e so must use incentive contracts
First-best: principal observes effort and pays w=c(e*) inducing optimal effort at minimum cost. Second-best: principal can't observe e, must offer incentive-compatible contract.
Question 8
Lesson L02 Β· Information
An efficiency wage is a wage above the market-clearing level. Why might a firm pay this?
Type: Short Answer
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Answer: Paying above market clears makes workers value their job more (cost of being fired rises). Workers exert more effort to avoid dismissal β moral hazard is reduced because the threat of unemployment is more credible and costly.
Efficiency wages solve moral hazard by making job loss costly enough to deter shirking.
Question 9
Lesson L02 Β· Information
Which contract feature aligns agent incentives with principal objectives?
Type: Multiple Choice
- A) Fixed salary (no performance link)
- B) Performance pay or equity stake β the agent shares in the outcome, making their effort profitable
- C) Caps on agent earnings
- D) Short contract duration
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Answer: B) Performance pay or equity stake β the agent shares in the outcome, making their effort profitable
Incentive compatibility requires the agent to benefit from the outcomes the principal cares about. Performance pay links agent reward to output, reducing moral hazard.
Question 10
Lesson L02 Β· Information
The participation constraint in a principal-agent problem requires:
Type: Multiple Choice
- A) The agent to earn zero profit
- B) The agent's expected utility under the contract to be at least their outside option (reservation utility) β otherwise the agent won't accept the contract
- C) The principal to observe effort
- D) The output to exceed costs
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Answer: B) The agent's expected utility under the contract to be at least their outside option (reservation utility) β otherwise the agent won't accept the contract
Participation constraint (IR constraint): E[U(w,e)] β₯ Εͺ (reservation utility). The principal must offer at least this to get the agent to participate.
Question 11
Lesson L03 Β· Information
In Spence's signalling model education is used as a signal even if it has no direct productivity effect because:
Type: Multiple Choice
- A) Employers value degrees
- B) Education is cheaper to obtain for high-ability workers β the cost difference creates a separating equilibrium where only high types find it worth signalling
- C) All workers benefit equally from education
- D) Government subsidises education
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Answer: B) Education is cheaper to obtain for high-ability workers β the cost difference creates a separating equilibrium where only high types find it worth signalling
Spence (1973): education cost is lower for high-ability types. If cost difference is large enough high types signal (get educated), low types don't β employers infer ability from education.
Question 12
Lesson L03 Β· Information
For a separating equilibrium in Spence's model: high type's cost of education c_H=1/ΞΈ where ΞΈ=2; low type cost c_L=1/1=1. Wage difference for signalling: w_H-w_L=$20. Does a separating equilibrium exist?
Type: Calculation
Show Answer
Answer: Yes if high type's net gain > 0: $20 - 1/2 = $19.5 > 0 and low type's net gain < 0: $20 - 1 = $19 > 0... check Riley condition
Riley condition: high type gains from signalling: w_H-w_L > c_HΓe* β $20 > 0.5e*. Low type must not mimic: w_H-w_L < c_LΓe* β $20 < e*. So e* must satisfy 20 < e* and 20 > 0.5e* β e* > 20 and e* < 40. Valid separating equilibrium exists for e* β (20,40).
Question 13
Lesson L03 Β· Information
Screening differs from signalling because:
Type: Multiple Choice
- A) Screening is always more efficient
- B) In signalling the informed party moves first (sends signal); in screening the uninformed party moves first (designs a menu of contracts to separate types)
- C) Screening is only used in insurance
- D) Signalling requires education
Show Answer
Answer: B) In signalling the informed party moves first (sends signal); in screening the uninformed party moves first (designs a menu of contracts to separate types)
Signalling: informed party acts first (job applicant gets degree). Screening: uninformed party designs self-selection mechanism (insurer offers deductible menu).
Question 14
Lesson L03 Β· Information
Is there a social waste from Spence's signalling equilibrium?
Type: Short Answer
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Answer: If education is purely a signal (no productivity benefit), the resources spent on education are socially wasteful β they only redistribute wage payments from low to high types without increasing total output. This is a social cost of information asymmetry.
Pure signalling without human capital investment represents deadweight loss from the information problem.
Question 15
Lesson L03 Β· Information
Australia's HECS-HELP system makes higher education accessible. From a signalling perspective this:
Type: Multiple Choice
- A) Eliminates all signalling
- B) Reduces the cost of signalling for all types β potentially reducing the separating power of education as a signal if low types can now also afford to get educated
- C) Increases signalling efficiency
- D) Has no effect on labour market signals
Show Answer
Answer: B) Reduces the cost of signalling for all types β potentially reducing the separating power of education as a signal if low types can now also afford to get educated
Lower education costs reduce the cost difference between types. If both types can afford education, it loses its signalling value and a pooling equilibrium may emerge.
Question 16
Lesson L04 Β· Market Structure
In a second-price (Vickrey) auction bidding your true value is a dominant strategy because:
Type: Multiple Choice
- A) You always win if you bid true value
- B) You pay only the second-highest bid β bidding true value is weakly dominant: overbidding risks paying more than value; underbidding risks losing a profitable auction
- C) The auctioneer sets prices
- D) All bidders have the same value
Show Answer
Answer: B) You pay only the second-highest bid β bidding true value is weakly dominant: overbidding risks paying more than value; underbidding risks losing a profitable auction
Vickrey auction: winner pays second-highest price. Bidding truthfully is dominant β no incentive to deviate whether you win or lose.
Question 17
Lesson L04 Β· Market Structure
The Revenue Equivalence Theorem states that under standard conditions all standard auction formats (English, Dutch, sealed first-price, sealed second-price) yield the same expected revenue. What conditions are required?
Type: Calculation
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Answer: Symmetric risk-neutral bidders, private independent values, efficient allocation to highest value bidder
Revenue Equivalence: if auction allocates to highest bidder and losing bidder with lowest value gets zero surplus, all standard auctions yield the same expected revenue to the seller.
Question 18
Lesson L04 Β· Market Structure
The winner's curse in common-value auctions means:
Type: Short Answer
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Answer: The winner of a common-value auction is the most optimistic bidder. Conditional on winning, they likely overestimated the value β the act of winning is bad news. Rational bidders shade bids below their estimate to account for this.
Winning a common-value auction signals you overestimated value β you should bid below your estimate.
Question 19
Lesson L04 Β· Market Structure
The Gale-Shapley deferred acceptance algorithm produces a stable matching where:
Type: Multiple Choice
- A) All participants are paired optimally
- B) No pair of agents would both prefer each other to their assigned match (no blocking pair) β the matching is stable
- C) All students get their first preference
- D) Hospitals always get their top candidate
Show Answer
Answer: B) No pair of agents would both prefer each other to their assigned match (no blocking pair) β the matching is stable
Stable matching: no blocking pair exists. Gale-Shapley guarantees stability; the proposing side (e.g. hospitals in NRMP) gets their best stable match.
Question 20
Lesson L04 Β· Market Structure
Australia's electricity wholesale market (NEM) uses a uniform price auction. Why is truth-telling not necessarily dominant in this format?
Type: Short Answer
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Answer: In a uniform-price auction all winning bidders receive the same clearing price. Large generators have incentive to bid above marginal cost (exercise market power) since their bid can affect the clearing price for all their output β unlike the Vickrey auction where payment depends only on others' bids.
Uniform-price auctions create strategic bidding incentives for pivotal sellers β unlike Vickrey.
Question 21
Lesson L05 Β· Consumer Theory
The unified framework of intermediate microeconomics connects preferencesβchoiceβdemand via:
Type: Multiple Choice
- A) Supply and demand curves only
- B) Utility maximisation: preferences define indifference curves; budget constraint gives the feasible set; optimisation finds demand β which aggregates to market demand
- C) Game theory
- D) General equilibrium only
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Answer: B) Utility maximisation: preferences define indifference curves; budget constraint gives the feasible set; optimisation finds demand β which aggregates to market demand
Consumer theory: preferences β utility function β utility max subject to budget β Marshallian demand β market demand. This is the core consumer theory chain.
Question 22
Lesson L05 Β· Production
On the production side the equivalent chain is technologyβcostsβsupply via:
Type: Calculation
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Answer: Production function β cost minimisation β cost function β profit maximisation β supply function
Production theory: f(L,K) β min cost subject to output β c(w,y) β max Ο = py-c(w,y) β y*(p,w). Same optimisation structure as consumer theory.
Question 23
Lesson L05 Β· Information
Information asymmetry is sometimes called the sixth market failure. Name the five standard market failures and add information as the sixth.
Type: Short Answer
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Answer: 1. Market power (monopoly/oligopoly). 2. Externalities. 3. Public goods. 4. Common resources. 5. Missing markets. 6. Information asymmetry (adverse selection, moral hazard, signalling failures).
Information problems cause market failure even when all five standard conditions hold.
Question 24
Lesson L05 Β· Consumer Theory
Behavioural economics challenges standard consumer theory by showing that:
Type: Multiple Choice
- A) Consumers always maximise utility
- B) Consumers exhibit systematic biases (loss aversion, present bias, anchoring) that violate rationality assumptions β markets may not efficiently aggregate preferences
- C) Firms always exploit consumers
- D) Prices are always wrong
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Answer: B) Consumers exhibit systematic biases (loss aversion, present bias, anchoring) that violate rationality assumptions β markets may not efficiently aggregate preferences
Behavioural micro: Kahneman and Tversky's prospect theory shows preferences violate expected utility theory. Present bias explains under-saving. These are ECOS2001-level extensions.
Question 25
Lesson L05 Β· Welfare
The key insight connecting the First Welfare Theorem to Australian economic policy is:
Type: Multiple Choice
- A) Government should manage all markets
- B) Competitive markets are efficient (First WT) β so policy interventions should be reserved for genuine market failures (externalities, public goods, market power, information failures), not general redistribution of income which is better addressed via lump-sum transfers (Second WT)
- C) All markets fail
- D) Competition policy is unnecessary
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Answer: B) Competitive markets are efficient (First WT) β so policy interventions should be reserved for genuine market failures (externalities, public goods, market power, information failures), not general redistribution of income which is better addressed via lump-sum transfers (Second WT)
The welfare theorems justify a mixed economy: use markets for efficiency, use lump-sum redistribution for equity, intervene only for genuine market failures.