Part A – Basic Concepts of Asymmetric Information (Q1–Q8)
1. Asymmetric information occurs when:
(A) All parties have the same information
(B) One party has more or better information than the other ✅
(C) Both parties have perfect knowledge
(D) Information is freely available to everyone
Explanation:
Asymmetric information means one side (buyer or seller) knows more about the transaction — e.g., seller knows product quality better.
2. The presence of asymmetric information may lead to:
(A) Perfect competition
(B) Market failure ✅
(C) Pareto efficiency
(D) Equilibrium at full employment
Explanation:
Unequal information distorts choices and contracts, often causing market inefficiency or failure.
3. Which of the following is NOT a consequence of asymmetric information?
(A) Adverse Selection
(B) Moral Hazard
(C) Market Signaling
(D) Price Discrimination ✅
Explanation:
Price discrimination relates to different pricing based on willingness to pay — not directly due to hidden information problems.
4. Information asymmetry violates which assumption of perfect competition?
(A) Free entry and exit
(B) Perfect knowledge ✅
(C) Homogeneous products
(D) Profit maximization
Explanation:
Perfect competition assumes all buyers and sellers are fully informed. Asymmetric information breaks this condition.
5. The study of markets with asymmetric information was developed prominently by:
(A) Keynes, Pigou, and Hicks
(B) Akerlof, Spence, and Stiglitz ✅
(C) Samuelson, Arrow, and Sen
(D) Marshall, Ricardo, and Walras
Explanation:
George Akerlof, Michael Spence, and Joseph Stiglitz shared the 2001 Nobel Prize for their work on information asymmetry.
6. An example of asymmetric information is:
(A) Buyer knowing car defects before seller
(B) Seller knowing car quality better than buyer ✅
(C) Both knowing all features
(D) Government fixing price ceiling
Explanation:
In Akerlof’s model, the seller knows whether the car is a “lemon” or a “peach,” while the buyer doesn’t — classic asymmetric information.
7. Which type of information problem occurs before a transaction?
(A) Moral Hazard
(B) Adverse Selection ✅
(C) Signaling
(D) Principal–Agent Problem
Explanation:
Adverse selection occurs before contracts are made — it’s caused by hidden information about risk or quality.
8. Which type of information problem occurs after a transaction?
(A) Adverse Selection
(B) Moral Hazard ✅
(C) Screening
(D) Asymmetric Signaling
Explanation:
Moral hazard arises after a deal is made — due to hidden actions that one party cannot monitor.
Part B – Adverse Selection (Q9–Q18)
9. Adverse selection means:
(A) Hidden information before contract ✅
(B) Hidden actions after contract
(C) Monitoring after contract
(D) Price discrimination by firm
Explanation:
Adverse selection occurs when one party withholds information before the transaction — leading to “bad” participants entering the market.
10. The concept of adverse selection was introduced by:
(A) Stiglitz
(B) Akerlof ✅
(C) Spence
(D) Arrow
Explanation:
George Akerlof’s paper “The Market for Lemons” (1970) analyzed how hidden information leads to market failure.
11. The “Market for Lemons” illustrates:
(A) Price discrimination
(B) Adverse selection ✅
(C) Monopoly pricing
(D) Externalities
Explanation:
In Akerlof’s example, used-car markets suffer because buyers can’t distinguish between good and bad cars.
12. In Akerlof’s lemons model, when buyers can’t distinguish product quality:
(A) Market price equals high-quality value
(B) Only high-quality goods are sold
(C) Average price causes good sellers to exit ✅
(D) Market efficiency increases
Explanation:
Good-quality sellers leave the market because the price doesn’t reflect their higher value → market collapse.
13. In insurance markets, adverse selection implies that:
(A) Low-risk individuals buy more insurance
(B) High-risk individuals are more likely to buy insurance ✅
(C) Everyone buys equal coverage
(D) Insurers can identify all risks
Explanation:
Since insurers can’t observe risk type, high-risk people self-select into buying more insurance.
14. In credit markets, adverse selection leads to:
(A) Lower interest rates
(B) Lenders offering less credit ✅
(C) Good borrowers dominating
(D) No impact on loan supply
Explanation:
Unable to distinguish good and bad borrowers, lenders raise interest rates or restrict credit, reducing loan supply.
15. Adverse selection is sometimes referred to as:
(A) Hidden Action Problem
(B) Hidden Information Problem ✅
(C) Hidden Incentive Problem
(D) Public Information Problem
Explanation:
It arises from hidden information that one side possesses prior to transaction.
16. In job markets, educational qualifications can serve as:
(A) Screening
(B) Signaling ✅
(C) Incentive constraint
(D) Hidden action
Explanation:
Michael Spence (1973) argued that education signals a worker’s ability to employers — reducing information asymmetry.
17. Screening refers to:
(A) Effort to hide information
(B) Method by which uninformed party extracts information ✅
(C) Promise of performance
(D) Concealing risk
Explanation:
Joseph Stiglitz’s concept — the uninformed side (e.g., insurer or employer) designs mechanisms to reveal the hidden characteristics.
18. Which of the following can reduce adverse selection?
(A) Signaling by informed parties ✅
(B) Reducing market competition
(C) Taxation
(D) Price control
Explanation:
Signaling (e.g., warranties, education, brand reputation) helps communicate private information and improve market outcomes.
Part C – Moral Hazard (Q19–Q27)
19. Moral hazard arises due to:
(A) Hidden information before contract
(B) Hidden actions after contract ✅
(C) Market competition
(D) Price rigidity
Explanation:
Moral hazard occurs when one party cannot observe the other’s actions after an agreement is made.
20. In insurance, moral hazard occurs when:
(A) Only high-risk people buy insurance
(B) Insured individuals behave more recklessly ✅
(C) Insurers raise premiums
(D) Information is perfect
Explanation:
After buying insurance, people may take less care since losses are covered — this is moral hazard.
21. Moral hazard occurs in the:
(A) Pre-contract stage
(B) Post-contract stage ✅
(C) Advertisement stage
(D) Screening stage
Explanation:
It arises after the agreement has been made and involves hidden or unobservable actions.
22. The principal–agent problem is an example of:
(A) Moral hazard ✅
(B) Adverse selection
(C) Price control
(D) Externality
Explanation:
When agents’ actions cannot be monitored, they may act against the principal’s interest — a moral hazard situation.
23. In moral hazard, incentives must be designed to ensure:
(A) Adverse selection
(B) Effort and performance alignment ✅
(C) Equal wages
(D) Higher interest rates
Explanation:
Contracts like bonuses, commissions, or performance pay align individual incentives with organizational goals.
24. Co-payment or deductibles in insurance help reduce:
(A) Adverse selection
(B) Moral hazard ✅
(C) Market signaling
(D) Free riding
Explanation:
By sharing part of the cost, insured persons remain cautious — mitigating risky behavior after insurance.
25. Monitoring and auditing are solutions to:
(A) Adverse selection
(B) Moral hazard ✅
(C) Inflationary gaps
(D) Monopoly power
Explanation:
Supervision ensures that agents act honestly and reduces hidden action problems.
26. The moral hazard problem can cause:
(A) Overuse of insured goods or services ✅
(B) Under-consumption of public goods
(C) Price rigidity
(D) Negative externality only
Explanation:
Because insured parties are shielded from costs, they tend to overconsume or behave less cautiously.
27. In the banking sector, moral hazard occurs when:
(A) Borrowers hide risk before loans
(B) Banks take excessive risks expecting government bailout ✅
(C) Banks charge high interest rates
(D) Depositors withdraw funds
Explanation:
If banks expect bailout (“too big to fail”), they may take higher risks — a moral hazard problem.
Part D – Comparative and Applied (Q28–Q30)
28. Difference between adverse selection and moral hazard is based on:
(A) Timing of the information problem ✅
(B) Type of market
(C) Nature of good
(D) Price elasticity
Explanation:
Adverse selection arises before contract (hidden info); moral hazard occurs after contract (hidden actions).
29. Principal–agent problem mainly deals with:
(A) Adverse selection before hiring
(B) Moral hazard after hiring ✅
(C) Information symmetry
(D) Price discrimination
Explanation:
Once the agent (employee) is hired, their effort can’t be perfectly monitored — a post-contract moral hazard.
30. Which policy measure can address both adverse selection and moral hazard?
(A) Reducing wages
(B) Improving transparency and information disclosure ✅
(C) Price ceilings
(D) Government subsidies
Explanation:
Improved information systems, reporting, and disclosure reduce both pre-contract (adverse selection) and post-contract (moral hazard) inefficiencies.