Scenario 1 (length: 0.5 page)
Some recent Super Bowl advertisements have spent very little time mentioning anything about their product--or even the name of the company. For example, the two-minute long Ram Trucks "Farmer" commercial (http://www.youtube.com/watch?v=AMpZ0TGjbWE) had only a few brief and almost unidentifiable views of their product until the last ten seconds of the commercial. Further, the name of the company was only mentioned in the last five seconds of that commercial. Explain how commercials of this type demonstrate the concept of signaling described in the textbook. In other words, why should consumers be convinced that the product being "advertised" is of high quality because of the airing of that commercial during the Super Bowl?
Scenario 2 (length: as needed)
Suppose there are two types of people who need health insurance; high-risk and low-risk consumers. High-risk consumers have a relatively high probability of needing expensive medical care and on average incur $2,000 of medical expenses per year. The high-risk consumers would be willing to pay up to $2,500 for insurance that covers all their medical bills. Low-risk consumers would be willing to pay up to $1,400 for full-coverage insurance and on average would incur on average $1,200 in medical bills. Assume 1/3 of all consumers are high-risk and the remaining 2/3 of consumers are low-risk. Consumers know whether they are high-risk or low-risk. The insurance company knows 2/3 of all consumers are low-risk but cannot identify which consumers are low-risk.
- 1)If all consumers bought insurance, what price must the insurance company charge to break even in expectation? That is, what price must the insurance company charge so that the expected payments equals the premium?
- 2)Which consumers would purchase insurance at that price?
- 3)Are there wealth-creating transactions that are not consummated because of the information asymmetry?
- 4)If the low-risk consumers were willing to pay $1,500 for the insurance, how would your answers to questions 2 and 3 change?
Scenario 3 (length: 0.5 - 1 page)
A struggling company currently has a total value of $700,000. It owes $500,000 from debt financing (assume these are loans from the bank if you wish). The value of the company to the owners is the difference between the total value and the amount owed to the debt holders. What is the current value of the firm to the owners?
Now assume that a project is presented to the owners that results in a loss of the entire value of the company with a probability of 50% and results in a gain in value of $500,000 with probability 50% (resulting in a total value of $1,200,000). Show that this in expectation decreases the firm's value, and explain why, in spite of that, the owners of the company would want to undertake the project.