Home » For each of the following, determine whether it represents moral hazard, adverse selection, both, or neither. A board of directors that compensates…

For each of the following, determine whether it represents moral hazard, adverse selection, both, or neither. A board of directors that compensates…

Q1. For each of the following, determine whether it represents moral hazard, adverse selection, both, or neither.

A. A board of directors that compensates their CEO primarily through stock options.

B. A doctor who performs a large number of in-office tests and is paid per test.

C. An elderly couple who elect a generous medical insurance policy.

D. A buyer who makes a large raise in bid at an auction to discourage other bidders.

E. An entry level employee who works in an open common space with all her other co-workers.

F. A supervisor who spends most of his time alone in his office and has one annual evaluation.

G. A financial advisor who receives his compensation on a flat fee basis.

H. A financial advisor who receives her compensation on a percentage of total funds basis.

I. A financial advisor who receives his compensation as half of all returns that the portfolio he created earns above the S&P 500 return.

Q2. Suppose prospective clerical workers fall into one of two categories in equal numbers: high productivity (HP) and low productivity (LP). An HP worker’s value to the firm is $30,000 per year; an LP worker’s value is $20,000 per year. A firm hires workers who stay an average of five years.

A. At the time of hiring, the firm cannot distinguish HP and LP workers. In this case, what wage will it offer its new hires? What two word phrase describes the problem that you are facing?

B. One option is for workers to attend college before taking a job. Suppose college has no effect on clerical productivity (its other virtues notwithstanding). For an HP worker, the expected total cost of attending a four-year college (accounting for possible scholarships) is $40,000. The expected cost for an LP worker is $60,000. Can HP workers effectively signal their productivity by attending college? What if the average job stay is only three years?

Q3. You are the CEO of a firm currently earning $10M/year in economic profits. Your head of marketing comes to you with what she calls a brilliant marketing campaign. The campaign costs $6M, and is a go-big-or-go-home campaign: there’s a 70% chance it will increase revenue by $9M, and a 30% chance it will increase revenue by only $4M. Do you approve the campaign?

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