A used car seller knows the car's transmission is about to fail, but a buyer test-driving it cannot tell. What does this situation illustrate?
Asymmetric information
✓
Moral hazard
Risk pooling
Loss aversion
Correct Answer
Asymmetric information
Asymmetric information exists when one party to a transaction knows more than the other, here the seller knowing about a defect the buyer cannot detect. Moral hazard is taking more risk because one is insured. Risk pooling is how insurance spreads losses across many people. Loss aversion is the tendency to feel losses more strongly than equal gains.
Category: Imperfect Information
Question 2
When information problems drive away most potential buyers and sellers, leaving only a few participants who must bargain over price, what kind of market results?
A thick market
A thin market
✓
A perfectly competitive market
A black market
Correct Answer
A thin market
A thin market has relatively few buyers and sellers, and severe information problems can shrink a market to this state. A thick market has many buyers and sellers. A perfectly competitive market has many participants and full information. A black market is an illegal market, not one defined by the number of participants.
Category: Imperfect Information
Question 3
If buyers judge a product's quality partly by its price, what may happen when a seller cuts its price?
Buyers will read the cut as a sign of high quality
The supply curve shifts to the right
Buyers may read the cut as a sign of low quality
✓
The good becomes a public good
Correct Answer
Buyers may read the cut as a sign of low quality
When price serves as a signal of quality, a lower price can suggest a worse product, so a price cut may fail to attract buyers. Buyers reading the cut as a sign of high quality reverses the signal. The supply curve shifts to the right describes a change in sellers' costs or numbers, not a seller's own price cut. The good becomes a public good is wrong because price changes do not make a good nonexcludable.
Category: Imperfect Information
Question 4
At no extra charge, a seller promises to repair or replace a television if it breaks within two years of purchase. What is this promise called?
A service contract
A money-back guarantee
A deductible
A warranty
✓
Correct Answer
A warranty
A warranty is a seller's promise to fix or replace a good for a set period, and it comes with the purchase. A service contract also covers repairs, but the buyer pays an extra fee for it. A money-back guarantee promises a refund rather than a repair. A deductible is the amount an insurance policyholder pays before coverage begins.
Category: Reducing Information Problems
Question 5
A homeowner pays $600 a year for fire insurance on a house that has a very small chance of burning down in any given year. What does the homeowner gain from buying the policy?
Protection against a large loss for a predictable cost
✓
A lower chance that the house will burn
An expected profit from the policy over time
A guaranteed refund if no fire occurs
Correct Answer
Protection against a large loss for a predictable cost
Insurance lets a person swap a predictable payment for protection against a rare but very large loss, because the payments of many policyholders are pooled to cover the few who suffer a loss. A lower chance that the house will burn is wrong because insurance does not change the risk of fire and can even reduce the care people take. An expected profit from the policy over time is wrong because payments must on average cover claims plus the insurer's costs, so the typical policyholder pays in more than they collect. A guaranteed refund if no fire occurs is wrong because the payment buys a year of coverage whether or not a loss happens.
Category: How Insurance Works
Question 6
Why did the Affordable Care Act, as originally passed, require people without employer or government coverage to buy health insurance or pay a fine?
To reduce the number of insurance companies
To bring healthy people into the insurance pool
✓
To end employer-provided health coverage
To raise the fees doctors charge per visit
Correct Answer
To bring healthy people into the insurance pool
Requiring everyone to buy coverage keeps low-risk, healthy people in the insurance pool, which reduces adverse selection and spreads costs over more people. The law did not aim to reduce the number of insurance companies; its exchanges were meant to increase competition. It did not end employer-provided health coverage. Raising the fees doctors charge per visit was not a goal of the requirement.
Category: Health Insurance
Question 7
A student with no credit history gets a car loan only after a parent legally agrees to repay it if the student does not. What role does the parent play?
Beneficiary
Policyholder
Cosigner
✓
Insurer
Correct Answer
Cosigner
A cosigner agrees to repay some or all of a loan if the borrower defaults, which reduces the lender's risk from not knowing the borrower well. A beneficiary is a person who receives payment from a policy or estate. A policyholder is a person who buys insurance. An insurer is a company that sells insurance coverage.
Category: Reducing Information Problems
Question 8
A state requires anyone who wants to work as an electrician to complete approved training and pass an exam. What credential is this?
A patent
A trademark
A warranty
An occupational license
✓
Correct Answer
An occupational license
An occupational license is a government-issued credential showing that a worker has the required training or has passed a test, which tells customers something about quality they cannot easily check. A patent protects an invention. A trademark protects a brand name or symbol. A warranty is a seller's promise to repair a good.
Category: Reducing Information Problems
Question 9
An insurer covers 100 drivers. In a year, 85 have no accident, 10 have accidents costing $3,000 each and 5 have accidents costing $12,000 each. Ignoring administrative costs and profit, what premium must each driver pay so the insurer exactly covers claims?
$900
✓
$6,000
$15,000
$7,500
Correct Answer
$900
Total claims are 10 x $3,000 + 5 x $12,000 = $30,000 + $60,000 = $90,000, and dividing by all 100 drivers gives $900 each. $6,000 divides total claims by only the 15 drivers who had accidents. $15,000 adds the two accident costs together. $7,500 is the simple average of the two accident costs.
Category: How Insurance Works
Question 10
Each homeowner in a risk group has a 2% chance of a $40,000 loss in a year. What is the actuarially fair annual premium for each member?
$80
$800
✓
$40,000
$8,000
Correct Answer
$800
An actuarially fair premium equals the expected payout: 0.02 x $40,000 = $800. $80 uses a probability of 0.2% instead of 2%. $40,000 is the full loss, which only a few members will suffer. $8,000 would correspond to a 20% chance of loss.
Category: How Insurance Works
Question 11
After buying full theft insurance, a shop owner stops locking the back door at night. What problem does this illustrate?
Adverse selection
Risk pooling
Moral hazard
✓
A thin market
Correct Answer
Moral hazard
Moral hazard occurs when having insurance leads people to take less care to prevent the insured loss, because the insurer bears the cost. Adverse selection is about who chooses to buy insurance, not how insured people behave afterward. Risk pooling is the spreading of losses across policyholders. A thin market is a market with few buyers and sellers.
Category: Moral Hazard
Question 12
An insurer charges everyone the same premium, and the people most eager to buy are those who know they face a high risk of loss. What is this problem called?
Moral hazard
Coinsurance
Loss aversion
Adverse selection
✓
Correct Answer
Adverse selection
Adverse selection arises when buyers know more about their own risk than the insurer does, so higher-risk people are more likely to buy, which pushes up the insurer's costs. Moral hazard is riskier behavior after becoming insured. Coinsurance is a cost-sharing arrangement. Loss aversion is a behavioral tendency to weigh losses more heavily than gains.
Category: Adverse Selection
Question 13
Which cost-sharing feature charges a patient a fixed amount, such as $20, each time the patient visits a doctor?
A copayment
✓
A deductible
Coinsurance
A premium
Correct Answer
A copayment
A copayment is a small fixed fee paid for each service, with insurance covering the rest. A deductible is a total amount the policyholder pays before insurance begins paying. Coinsurance is a percentage of each bill rather than a fixed fee. A premium is the regular payment for the policy itself, not a charge per visit.
Category: Moral Hazard
Question 14
Why does employer-provided group health insurance tend to keep an insurer's pool from being made up mostly of high-risk people?
It covers only workers who are already sick
It covers workers of all risk levels together
✓
It lets workers join only after they get sick
It makes each worker pay the full cost of care
Correct Answer
It covers workers of all risk levels together
Group coverage enrolls whole groups of employees, healthy and less healthy alike, so the insurer's pool contains a mix of risks rather than only those who expect large claims. Covering only workers who are already sick would make adverse selection worse. Letting workers join only after they get sick would do the same. Making each worker pay the full cost of care would defeat the purpose of insurance.
Category: Adverse Selection
Question 15
A health plan has a $1,000 deductible, after which it pays 80% of covered costs and the patient pays 20%. How much does a patient with a $6,000 covered bill pay in total?
$1,200
$2,200
$2,000
✓
$1,000
Correct Answer
$2,000
The patient pays the first $1,000, then 20% of the remaining $5,000, which is $1,000, for a total of $2,000. $1,200 takes 20% of the whole bill and ignores the deductible. $2,200 adds the deductible to 20% of the full $6,000 instead of 20% of what is left. $1,000 counts only the deductible.
Category: Moral Hazard
Question 16
An employer hires a worker for a 90-day trial during which the employer can easily let the worker go if performance is poor. What is this tool for dealing with imperfect information called?
An occupational license
A service contract
A money-back guarantee
A probationary period
✓
Correct Answer
A probationary period
A probationary period lets an employer observe a new worker's actual performance before committing to the hire, reducing the risk of not knowing the worker's qualities. An occupational license is a government credential. A service contract covers repairs on a purchased good. A money-back guarantee is a seller's promise of a refund.
Category: Reducing Information Problems
Question 17
A health maintenance organization receives a fixed payment for each enrolled person, no matter how many services that person uses. What incentive does this create?
To avoid unnecessary treatments
✓
To order as many tests as possible
To raise the fee charged for each visit
To enroll only people who are already sick
Correct Answer
To avoid unnecessary treatments
Because its revenue does not rise with the number of services, the organization gains by avoiding care that does not improve health. Ordering as many tests as possible is the incentive under fee-for-service payment. Raising the fee for each visit is not how such an organization is paid. Enrolling only people who are already sick would raise its costs without raising its payments.
Category: Moral Hazard
Question 18
A state caps auto insurance premiums below the level that would cover insurers' expected claims and costs. What does economic reasoning predict?
More insurers enter the market
Some insurers leave the market
✓
Claims fall to match the lower premiums
Accidents become less frequent
Correct Answer
Some insurers leave the market
If premiums cannot cover expected claims and costs, insurers lose money on each policy, so some stop selling coverage in that state, and any remaining losses must be covered by taxpayers or other buyers. More insurers entering the market is the opposite of what losses cause. Claims falling to match the lower premiums is wrong because a price cap does not change how often accidents happen. Accidents becoming less frequent is unrelated to the premium cap.
Category: Insurance Regulation
Question 19
Which government program, funded by employers, pays benefits to workers who are injured on the job?
Unemployment insurance
Deposit insurance
Workers' compensation
✓
Pension insurance
Correct Answer
Workers' compensation
Workers' compensation pays benefits to employees hurt at work and is paid for by employers. Unemployment insurance pays benefits to people who lose their jobs. Deposit insurance protects bank deposits up to a limit if a bank fails. Pension insurance partially protects workers' pensions if a company goes bankrupt.
Category: How Insurance Works
Question 20
When buyers cannot verify quality and so will pay only an average price, which sellers are most likely to leave the market?
Sellers of low-quality goods
Sellers with the most customers
Sellers who offer refunds
Sellers of high-quality goods
✓
Correct Answer
Sellers of high-quality goods
If buyers pay only an average price, owners of high-quality goods receive less than their goods are worth and may refuse to sell, leaving mostly low-quality goods behind, as in the market for used cars. Sellers of low-quality goods gain from an average price, so they stay. Sellers with the most customers have the most to gain from staying. Sellers who offer refunds are reassuring buyers, which helps them stay in the market.
Category: Imperfect Information