Lemon (L) Normal (N) Total
Return (R) .02 .06 .08
Keep (K) .02 .90 .92
Total .04 .96 1.00For instance, one computes the first row: Pr(L & R) (.5)(.04) .02,
and Pr(N & R) (1/16)(.96) .06. Thus, we find Pr(LƒR) .02/
(.08) .25. Of all cars returned, 25 percent are lemons. In turn,
Pr(LƒK) .02/.92 .021.
b. We see that the return policy screens out half of the lemons (a
substantial benefit to customers), but at the cost that about 6 percent
of normal-quality cars will be returned as well.- a. With equal chances of both types of workers, the firm offers a wage of
$25,000 (equal to the workers’ average productivity).
b. By attending college, HP workers can distinguish themselves from LP
workers (i.e., signal their higher productivity). Consider an
equilibrium in which workers with college educations are paid
$30,000, and all others are paid $20,000. By going to college, HP
workers increase their incomes by $10,000 per year or $50,000 over
their expected five-year job tenure. Since these added earnings
exceed the cost of a college education ($40,000), it pays HP workers
to go to college. Not so for LP workers whose college costs are
$60,000. Thus, the signaling outcome is, indeed, an equilibrium.
However, if the average job stay is only three years, this signaling
equilibrium breaks down. - If the bill is split five ways, each time a couple orders an extra menu item
(say, an expensive shrimp cocktail or a baked Alaska dessert), its share of
the extra cost is only 20 percent. The other couples pay for 80 percent of
the cost. Moral hazard occurs because couples will tend to overindulge
themselves in expensive items because they bear only a fraction of the
costs. The couple who mistakenly expects separate checks is in double
jeopardy. By economizing, it forgoes a lavish meal, yet it pays for the
others’ extravagance. - a. Guaranteed deliver is notefficient, because it forces firm X to deliver
even when its cost of doing so is greater than firm Y’s benefit
($100,000).
b. Setting the penalty at $50,000 is also NOT efficient. For instance, firm
Y would default with a cost such as c $70,000 (it’s cheaper to pay
the penalty), even though firm X’s value is much higher ($100,000).
Setting the penalty at exactly $100,000 is efficient. This contingent
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