Reference no: EM133184600

1. We have discussed how signals can be used to solve adverse selection problems.

Adverse Selection: One party cannot observe certain characteristics of the informed party, and as a result a disproportionate share of people with less desirable characteristics enter the market.For example, if I offer bike insurance, I cannot observe which individuals are more or less likely to ruin their bikes, as a result I will get a disproportionate share of high risk insurers.

Provide a unique and personal example of adverse selection and discuss the possible signals that could be used to identify low and high quality types. Which signal would be most effective and why?

2. In class we have discussed extensively the notion of moral hazard.

Moral Hazard: One party cannot observe the behavior of the informed party, and as a result the informed party will be more likely to act in a way that harms the uniformed party. For example, if I offer bike insurance, I cannot observe how people will behave one they buy my insurance. They are likely to behave in more risky (and hence costly) ways.

You may have heard of the economic problem of "free riding."

How can moral hazard be thought of as a type of free riding?

Please explain fully and provide an example to illustrate your answer.