Edexcel IAL Economics: Imperfect information, moral hazard, bubbles (YEC11) – Practice Questions

These are original questions written for Marlbridge, for revision and practice on this content. They are not reproduced past-paper questions, and they do not replicate the exam’s exact structure, question count or mark tariffs – examination boards hold copyright in their own papers. Use these alongside the official past papers from your board or school.

These questions cover section 1.3.5 Market failure, items 4 to 6, of the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification (YEC11), Issue 2, June 2018. This is Unit 1 content, labelled IAS and also part of the full IAL. All countries, firms and figures are invented.

Links: study guide, revision notes, Edexcel economics hub, printable checklist and free 10-minute diagnostics.

Questions

1. Distinguish between symmetric and asymmetric information. [2]

2. A vaccination check costs 70. Without it, a person in Country B has a 6% chance of needing treatment costing 1,800. The person believes the chance is 2%. Calculate the true and the perceived expected cost of treatment, and explain what the person will do and why this is a misallocation. [4]

3. A degree costs 90,000 in fees and forgone earnings. A student expects extra pay of 2,500 a year for 28 years. The true extra pay is 5,500 a year. Ignore discounting. Calculate the perceived and true net benefit and explain the market failure. [5]

4. A worker in Country C could save 2,000 a year at 5% a year, either for 30 years or for 20 years. Calculate the value of each pot (to the nearest whole number) and the cost of the shorter period. Explain why information gaps may lead people to choose the shorter one. [6]

5. An insurer in Country D has 600 careful drivers (expected claims 120 a year) and 150 risky drivers (expected claims 700). Careful drivers value cover at 160. The insurer cannot tell the groups apart. Calculate the break-even premium for all drivers. Explain what happens next and how insurance output compares with the optimum. [5]

6. A small insurer covers 2,000 delivery vans. It prices on a 5% annual claim chance and an average claim of 3,200. (a) Explain how moral hazard can occur here. [2] (b) After cover begins, the claim chance is 7.5%. Calculate the extra annual cost to the insurer and the premium rise needed to break even. [3] (c) Explain two effects of this moral hazard on consumers. [3]

7. A bank has equity of 30 and can lend 600. A safe option returns +30. A risky option has a 50% chance of +100 and a 50% chance of −70. (a) Calculate the expected return of each option for the economy, and for the bank if the state covers losses beyond its equity. [4] (b) Explain how this moral hazard affects consumers, producers, workers and governments. [4]

8. A housing price index in Country E over five years reads 100, 112, 130, 156, 190. Rent on a typical house is 9,000 a year, and the house cost 150,000 at the start. (a) Calculate the percentage rise in each year and the rental yield at the start and end. [3] (b) Explain how these figures suggest a bubble is forming. [2]

9. A buyer purchases a house for 320,000 with a 15% deposit. Prices then fall 35%. (a) Calculate the buyer’s equity after the fall. [2] (b) Explain two effects of the fall on the wider economy. [4]

10. A share has a price of 80 and earnings per share of 8. At the peak of a boom the price is 360 and earnings per share 9. Later the price is 140. (a) Calculate the price-earnings ratio at the start and the peak, and the percentage fall from peak to 140. [3] (b) Explain two effects of the fall on firms and workers. [3]

11. Evaluate whether the market failures caused by moral hazard in banking and by bubbles in housing and shares impose their largest costs on governments rather than on consumers, producers and workers. [12]

Answers

1. Symmetric: both parties know the same about the product [1]. Asymmetric: one party knows more than the other, such as a seller knowing quality [1]. [2] Examiner insight: Answers that give one example of each side usually show clearer understanding than bare definitions.

2. True expected cost: 0.06 × 1,800 = 108 [1]. Perceived: 0.02 × 1,800 = 36 [1]. Perceived cost is below 70, so the person skips the check [1]. The true cost exceeds 70 by 38, so too little is consumed compared with the optimum, a misallocation [1]. [4] Examiner insight: Show both figures against the price of 70. A comparison turns working into an explanation.

3. Perceived benefit: 2,500 × 28 = 70,000 [1]. Perceived net: 70,000 − 90,000 = −20,000, so no enrolment [1]. True benefit: 5,500 × 28 = 154,000 and net +64,000 [1]. A worthwhile investment is not made, so too little education is consumed [1]. Cause: an information gap about future earnings, so private perception differs from true benefit [1]. [5] Examiner insight: Name the gap precisely, such as future pay, and say that the quantity is too low.

4. Thirty years: 2,000 × (1.05³⁰ − 1)/0.05 = 132,878 [1]. Twenty years: 2,000 × (1.05²⁰ − 1)/0.05 = 66,132 [1]. The shorter period costs 66,746 [1]. Contributions fall only from 60,000 to 40,000 [1]. Many people cannot see how growth compounds, and the payoff is decades away [1]. They under-save, so too little is provided for retirement [1]. [6] Examiner insight: Pair each number with its meaning. Give the comparison of contributions to show why the gap is hidden.

5. Total expected cost: 600 × 120 + 150 × 700 = 72,000 + 105,000 = 177,000 [1]. Divide by 750: 236 [1]. Careful drivers value cover at 160, below 236, so they leave [1]. Only risky drivers remain and the break-even premium rises towards 700 [1]. Cover worth 160 and costing 120 is not traded, so output is below the optimum [1]. [5] Examiner insight: Follow the chain step by step, from the average premium to who leaves and what happens to cost.

6. (a) Once covered, owners bear less of the cost of a claim, so they take less care [1], and the insurer cannot observe this behaviour [1]. [2] (b) Original expected claim: 0.05 × 3,200 = 160. New: 0.075 × 3,200 = 240 [1]. Extra: 80 per van, so 2,000 × 80 = 160,000 [1]. Premium rise: 80/160 = 50% [1]. [3] (c) Higher premiums fall on all customers, including careful ones [1]. Insurers may restrict cover or add excesses, leaving customers with less protection [1]. Careful customers subsidise careless ones [1]. [3] Examiner insight: A strong answer says who ends up paying, not just that cost rises.

7. (a) Safe: +30 [1]. Risky for the economy: 0.5 × 100 + 0.5 × (−70) = 15 [1]. Risky for the bank: loss limited to 30, so 0.5 × 100 + 0.5 × (−30) = 35 [1]. The bank prefers risky (35 above 30), though the economy loses (15 below 30), and the state bears 0.5 × 40 = 20 [1]. [4] (b) Consumers: depositors may monitor less, and credit expands then contracts [1]. Producers: cheap credit encourages borrowing and then a shortage after losses [1]. Workers: pay linked to risk-taking, and job losses if the bank fails [1]. Governments: bailout costs, higher debt or taxes [1]. [4] Examiner insight: Cover all four groups and give a direction for each. A list of names alone gains little.

8. (a) Rises: 12/100 = 12%; 18/112 = 16.07%; 26/130 = 20%; 34/156 = 21.79% [1]. Yield at start: 9,000/150,000 = 6% [1]. End price: 150,000 × 1.9 = 285,000, yield 9,000/285,000 = 3.16% [1]. [3] (b) Rises are accelerating, a sign of feedback from expectations [1]. Price has run well ahead of rent, so yield has almost halved and price has moved away from fundamental value [1]. [2] Examiner insight: Use the figures to support the claim, then use cautious language such as “suggests”.

9. (a) Deposit: 0.15 × 320,000 = 48,000, so loan 272,000 [1]. New value: 320,000 × 0.65 = 208,000 and equity 208,000 − 272,000 = −64,000 [1]. [2] (b) Owners with negative equity cut spending [1] and find it hard to move, reducing mobility [1]. Builders face unsold stock and cut jobs [1], and tax revenues fall while bank losses may need state support [1]. [4] Examiner insight: Tie each effect to a group and finish with the consequence.

10. (a) Start: 80/8 = 10. Peak: 360/9 = 40 [1]. Fall: (140 − 360)/360 = −61.1% [1]. The percentage uses the peak as base [1]. [3] (b) Firms that raised funds in the boom may find new finance scarce after the fall, so they cut investment [1]. Workers face redundancies [1] and lower pension values if funds hold shares [1]. [3] Examiner insight: Say which base the fall uses; for a fall from a peak, the peak is the base.

11. Points for the claim: governments carry bailout and guarantee costs [1], lose tax revenue when assets crash [1], and must fund welfare as unemployment rises [1]. Those costs reach taxpayers later [1]. Points against: consumers lose savings, homes and credit directly [1], workers lose jobs and pay [1], and producers face credit shortages [1]. Both depend on the scale of debt and how far the state has to act [1]. Governments differ in resources and in whether they intervene [1]. Costs fall on groups at different times [1]. Judgement: governments bear a large share when they rescue banks, but households and workers often bear the more lasting losses [1], because rescue costs are spread across many taxpayers while job loss and negative equity hit individuals heavily [1]. [12] Examiner insight: Weigh groups against each other and reach a supported conclusion rather than listing effects.

Where marks are usually lost

• Calculating expected cost but not comparing it with the price.
• Saying “too much” or “too little” with no reference to the optimum.
• Treating moral hazard as dishonesty rather than a response to incentives.
• Confusing the pre-deal information gap with post-deal behaviour.
• Covering only one or two of the four groups.
• Using the wrong base for a percentage fall.
• Writing about housing when asked about shares.
• Evaluating with no judgement at the end.

Next steps

• Re-read the study guide and use the revision notes.
• Tick off coverage on the printable checklist or the hub.
• Take one of the free 10-minute diagnostics.
• Book a free trial class: /trial/.

Official syllabus

Source: Pearson Education Limited, Edexcel International Advanced Subsidiary/Advanced Level in Economics (specification, Issue 2, June 2018; first teaching September 2018), section 1.3.5 Market failure, items 4 to 6.