Pepperdine University

FINC 655

Chapter 20

Multiple Choice Questions

1)Which of the following is an example of moral hazard?

1. 1. Reckless drivers are the ones most likely to buy automobile insurance. [this is an example of adverse selection as it relates to different types of drivers.]
   2. Retail stores located in high-crime areas tend to buy theft insurance more often than stores located in low-crime areas. [this is an example of adverse selection as it relates to different types of stores.]
   3. Drivers who have many accidents prefer to buy cars with air bags. [this is an example of adverse selection as it relates to different types of drivers.]
   4. Employees recently covered by the company health plan start going to the doctor every time they get a cold. [unlike the other answers, this is an example of moral hazard as each same individual takes a different levels of risk in the presence of insurance than in its absence.]

2. In a bad economy, a CEO has a 4% chance of meeting earnings estimates at regular effort, and a 5% chance at extraordinary effort. Extraordinary effort costs the CEO $10,000. How large of a bonus should the CEO be paid for meeting estimates to encourage extraordinary effort?
   1. $100,000 [$100,000 earned 5% of the time is worth less than the cost of extraordinary effort.]
   2. $200,000 [This is insufficient since the CEO has an almost equal chance of meeting estimates at regular effort as at extraordinary effort.]
   3. $250,000 [The answer should account for the additional likelihood of meeting estimates from extraordinary effort.]
   4. $1,000,000 [extraordinary effort provides an extra 1% chance of meeting estimates. Therefore, the bonus must be at least $10,000/1%.]

3. A salesperson can put in regular effort (resulting in a 40% chance of sale) or high effort (60% chance of sale). If high effort costs the salesperson $20 more than regular effort, how large of a per-sale bonus is required to encourage high effort?
   1. $12 [this is less than the extra cost of effort and therefore would not be worth it for the salesperson.]
   2. $20 [a $20 bonus earned 60% of the time does not offset a $20 cost of effort.]
   3. $33.33 [this would exactly compensate for the extra cost of effort (60% x $33.33 = $20), but does not account for the fact that the salesperson has a good chance of earning the bonus at regular effort as well.]

1. 4. $100 [high effort results in an extra 20% chance of earning a bonus and costs $20. Therefore, the bonus must at least satisfy (20%)b=$20.]

4. Which of the following is not an example of a process designed to combat moral hazard problems?
   1. Banks include restrictive covenants in loan agreements. [this prevents bank customers from taking excessive risks with the bank’s capital.]

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1. 2. Universities have students complete evaluations of professor performance at the end of a class. [This helps prevent shirking by faculty]
   3. Insurance companies require applicants to provide medical history information as part of the application process. [this combats adverse selection rather than moral hazard.]
   4. Employers regularly monitor employee performance. [employees have less incentive to work hard than employers want since part of the generated profits go to the employer.]

5. Which of the following is an example of moral hazard?
   1. High-quality products being driven out of a market by low quality products. [this is an example of adverse selection.]
   2. A local charity raising insufficient funds because no one contributes, expecting that their neighbors will. [this is an example of free riding]
   3. A bakery defaults on its loan because of a new consumer fear of carbohydrates. [this is the result of the usual risk of lending and is not due to the bakery taking excessive risk.]
   4. A corporation uses a business loan secured for one investment on another, higher-risk investment. [the corporation takes excessive risks because the lender bears the downside.]

6. Which of the following is not an example of moral hazard?
   1. People are more likely to lock their own car than a rental car. [people exercise less care with a rental car as they do not bear the downside to the same degree as with their own car.]
   2. Skateboarders attempt more difficult maneuvers when wearing a helmet. [the helmet “insures” partially against risk, leading to greater risk-taking behavior.]
   3. Bad salespeople are less drawn to commission-based jobs. [this is an example of adverse selection, as it differentiates types of people, not their actions.]
   4. People with fire insurance are less likely to install smoke alarms. [people with insurance take less care.]

7. Which of the following is true?
   1. Moral hazard is primarily an issue prior to a transaction. [moral hazard arises when people take different actions because of the transaction (such as purchasing insurance).]
   2. Adverse selection is primarily an issue after a transaction. [adverse selection results from different willingness to enter into a transaction.]
   3. Moral hazard is the result of an information asymmetry. [moral hazard arises from hidden actions.]
   4. Resolving adverse selection also resolves moral hazard. [while related, these are different types of information asymmetry.]

8. Restrictive covenants on loans are used to avoid
   1. moral hazard. [restrictive covenants attempt to minimize excessive risk taking as a result of moral hazard.]
   2. adverse selection. [restrictive covenants attempt to control hidden actions.] 3