Principal's Response to Suboptimal Agent Care
In a hidden-action scenario, the agent's choice to exert a level of care that is privately optimal but socially insufficient increases the probability of a bad outcome. The principal, anticipating this behavior, compensates for the heightened risk by raising the price of the contract, such as by charging a higher insurance premium or a higher interest rate on a loan.
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The Economy 2.0 Microeconomics @ CORE Econ
Ch.10 Market successes and failures: The societal effects of private decisions - The Economy 2.0 Microeconomics @ CORE Econ
Introduction to Microeconomics Course
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CEO Incentives and Corporate Strategy
Socially Optimal Level of Care
Agent's Privately Optimal Level of Care
Comparison of Socially Optimal vs. Privately Optimal Care
Principal's Response to Suboptimal Agent Care
Salesperson Effort and Commission Structure
A freelance software developer is hired by a client to build an application. The developer is paid a fixed fee for the project, regardless of the final quality. The developer's extra effort (e.g., more rigorous testing, code optimization) increases the long-term value of the application for the client, but this extra effort is personally costly for the developer in terms of time and energy. Why is the developer likely to choose a level of effort that is less than what would be best for the client and developer combined?
A country implements a new economic policy that results in a 15% increase in the average income for the poorest 10% of its population. During the same period, the average income for the wealthiest 10% of the population remains unchanged. How would this change affect the country's rich/poor ratio, which is used as a measure of internal income inequality?
Tenant's Upkeep of a Rented Apartment
An individual buys fire insurance for their home. They can take costly precautions (e.g., installing better smoke detectors) to reduce the risk of a fire. This benefits both the homeowner (by protecting their property) and the insurance company (by reducing the likelihood of a payout). Match each component of this situation to its correct economic description.
A beekeeper is paid a fixed fee to place hives next to an apple orchard, which increases the orchard's fruit yield through pollination. The beekeeper can undertake a costly action—purchasing more productive but more expensive queen bees—which would further increase the orchard's yield. True or False: Because this action increases the total value created, the beekeeper has a sufficient incentive to purchase the more expensive queen bees.
Restaurant Profitability and Manager Effort
A team of two programmers is working on a project. Their final bonus is based on the total profit from the project, which is split equally between them. The profit depends on the combined effort of both programmers. Each programmer individually decides how much effort to put in, which is personally costly in terms of time and energy. Which of the following best explains why the total effort exerted by the team is likely to be less than the level that would maximize their combined bonus?
Legal Contingency Fees and Effort Allocation
Learn After
Under-provision of Insurance due to Moral Hazard
Credit Constraints as a Consequence of Hidden Actions in Lending
Risk Adjustment in Lending
A commercial lender is evaluating loan applications from two small businesses, 'Innovate Inc.' and 'Steady Corp.' Both businesses operate in the same industry, have similar financial histories, and are seeking the same loan amount for expansion. However, the loan to Innovate Inc. is for a high-risk, high-reward research project with outcomes that are difficult for the lender to observe, while the loan to Steady Corp. is for purchasing standard, easily tracked equipment. The lender, anticipating that the managers of each firm will act in their own best interest after receiving the funds, decides to charge a higher interest rate to Innovate Inc. Which of the following statements best explains the lender's decision?
Match each concept related to the energy basis of an economy with its correct description.
An insurance company offers a comprehensive travel policy that covers lost luggage. The company cannot observe the level of care each traveler takes with their belongings after purchasing the policy. The company anticipates that, on average, insured travelers will be slightly less vigilant than uninsured travelers, leading to a higher probability of claims. Given this unobservable behavior, which of the following best explains the company's most likely pricing strategy?
Salesperson Compensation Strategy
Landlord's Risk Mitigation Strategy
An auto insurance company is setting premiums for two groups of drivers. Group A consists of drivers who have installed an optional, verifiable anti-theft device in their cars. Group B consists of drivers who have not. The company cannot observe day-to-day actions like how carefully each driver locks their car or where they choose to park. The company should charge the same premium to both groups because the fundamental problem of unobservable driver care exists for all policyholders.
A principal (e.g., an employer, lender, or insurer) anticipates that an agent (e.g., an employee, borrower, or policyholder) may not act with the level of care that is most beneficial for both parties combined, because the agent's actions are not fully observable. Match each scenario describing this situation with the principal's most likely preemptive response.
Product Warranty Pricing Strategy
A tech firm hires a freelance developer for a project with a single, fixed payment upon completion. The firm cannot monitor the developer's day-to-day effort, only the final product. The firm anticipates that the developer, who bears the full cost of their own effort, may deliver a product that meets the minimum requirements but lacks the high level of quality and robustness that would be ideal for the firm. Based on this anticipation, which of the following contract adjustments is the most direct and logical way for the firm to protect its interests?
An insurance company offers a comprehensive travel policy that covers lost luggage. The company cannot observe the level of care each traveler takes with their belongings after purchasing the policy. The company anticipates that, on average, insured travelers will be slightly less vigilant than uninsured travelers, leading to a higher probability of claims. Given this unobservable behavior, which of the following best explains the company's most likely pricing strategy?