Asymmetry of Information


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Problem 16
You have seen how asymmetric information can reduce the average quality of products sold in a market,
as low-quality products drive out high-quality products. For those markets in which asymmetric
information is prevalent, would you agree or disagree with each of the following?
a. The government should subsidize Consumer Reports.
b. The government should impose quality standards – firms should not be allowed to sell low-
quality items.
c. The producer of a high-quality good will probably want to offer an extensive warranty.
d. The government should require all firms to offer extensive warranties.

Problem 17
UNIVERSAL SAVINGS & LOANS has $1000 to lend. Risk-free loans will be paid back in full next year with
4% interest. Risky loans have a 20% chance of defaulting (paying back nothing) and 80% chance of
paying back in full with 30% interest.
a. How much profit can the lending institution expect to earn? Show that the expected profits are
the same whether the lending institution makes risky or risk-free loans.
b. Now suppose that the lending institution knows that the government will “bail out” UNIVERSAL
if there is a default (paying back the original $1000). What type of loans will the lending
institution choose to make? What is the expected cost to the government?
c. Suppose the lending institution doesn’t know for sure that there will be a bail out, but one will

occur with probability P. For what values of P will the lending institution make risky loans?

Explanation & Answer

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