Explain the difference between moral hazard and adverse selection


SKU: solviv28(2) Category:

Suppose the company price discriminates between retail consumers and dental customers


1. Tilers is a rapidly  growing chain of  ceramic tile outlets that caters to the do-it-yourself home remodeling market. In 2011,33 stores were operated in small to medium-size metropolitan markets. An in-house study of sales by these outlets revealed the following (standard errors in parentheses):

Q = 4 – 5P + 2A + 0.21 + 0.25HF

(3)  (1.8)  (0.7)  (0.1)    (0.1)

R² = 93%, F =14.39

Here, Q is title sales (in thousands of cases), P is title price (per case), A is advertising expenditures (in thousands of dollars), I is disposable income per household (in thousands of dollars), and HF is household formation (in hundreds).

a. Fully evaluate and interpret these empirical results.

b. Is quantity demanded sensitive to “own’ price?

c. Austin, Texas, was a typical market covered by this analysis. During 2011 in the Austin market, price was $5, advertising was $30,000, income was an average $55,000 per household, and the number of household formations was 4,000. Calculate and interpret the relevant advertising point elasticity.


2. The following chart shows the hours required to make 1 unit of computer or TV in two countries: the U.S. and Taiwan


1 Computer1 TV
US1.5 hours8 hours
Taiwan1 hour5 hours


A) Which country has an absolute advantage in the producing computers and why?

B) Which country has a comparative advantage in producing computers? Explain clearly.


3. Do operating strategies of average cost minimization and profit maximization always lead to identical levels of output? Explain


4. The Canadian Competition Board seeks to ensure that the process of bringing new low- cost generic alternatives to the marketplace and into the hands of consumers is not impeded in ways that are anti- competitive . To illustrate the potential  for economic profits from delaying drug competition for one year, consider cost and demand relationships for an important brand-name drug set to lose patent protection:

TR = $10.25Q – $0.01Q²

TC =$625 + $0.25Q + $0.0025Q²

where TR is total revenue, Q is about , TC is total cost, including a risk-adjusted normal rate of return on investment. All figures are in thousands.

a. Determine the profit- maximizing price/outputs solution and economic profits prior to the expiration of patent protection

b. Calculate the firm’s competitive market equilibrium price/output solution and economic profits following the expiration of patent protection and onset of generic competition.


5.Explain the difference between moral hazard and adverse selection. Give an example of each.


6. Radio city promises that if you can find a lower price within 30 days, it will refund the difference. Do consumers benefit from this policy? Explain


7. From a CNBC interview the other day with the CEO of Ritz Carleton:

Interview: How come the Ritz charges extra for WIFI? That is annoying.

CEO: <blows off the question>

Interviewer: But WIFI is free at the Motel 6.

CEO: :Look. We have to make money.

a. Explain why the Ritz-Carleton charges extra for WIFI.

b. Given (a), would you expect Ritz Carleton to have a large or small markup on WIFI?

c. Gives at least two possiable reasons why Motel 6 does not charge extra.


8. In Canada any contract, combination or conspiracy in restraint of trade is illegal. In practice, this means it is against the law to control or attempt to control the quantity, price or exchange of goods and services. In addition to this legal prohibition, potential conspirators face practical problems in any overt or tacit attempt at collusion. To illustrate the problems encountered,consider the following profit payoff matrix faced by two potential conspirators in a one-shot, simultaneous-move game. The first number in each cell is firm A’s profit payoff; the second number is the profit payoff to firm B.

a. Is there a dominant strategy and a Nash equilibrium strategy for each firm? If so, what are they?(your answer should include an explanation of  Nash equilibrium)

b. If the firms agreed to collude and charge high prices, both would and joint profits of $50 million would be maximized. However, the joint high-price strategy is not a stable equilibrium. Explain.


9. A maker of a particular chemical which has use both in the dental industry (d) and to retail consumers (c), wishes to price discriminate. Demand in the two markets, and total costs are:

Pd = 210 – 10Qd

Pc =110 – 5Qc

TC = 100 + 10 (Qd + Qc)

a. Suppose the company price discriminates between retail consumers and dental customers. Calculate the optimal price and quantity in each market.

b. Calculate the price elasticity in each market. Which type of type of customer is more price sensitive and how is that reflected in the price?

c. Give a possible reason why price discrimination might not work in this case.




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