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Module 2 Quiz: Incentives and Human Behavior

Test your understanding of the key concepts from Module 2. Each question has one correct answer. Click "Show Answer" to check your response.

1. What defines a Nash equilibrium?

  1. The outcome that maximizes total welfare for all players
  2. An outcome where no player can improve by unilaterally changing their strategy
  3. The outcome where all players use the same strategy
  4. An outcome that requires players to cooperate
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The correct answer is B. A Nash equilibrium is a set of strategies --- one for each player --- such that no player can improve their payoff by switching to a different strategy, given what everyone else is doing. It is not necessarily the outcome that maximizes total welfare (A) --- the prisoner's dilemma has a Nash equilibrium that is collectively suboptimal. It does not require identical strategies (C) or cooperation (D); it applies specifically to non-cooperative games where players act independently.

Concept Tested: Nash Equilibrium

2. In the prisoner's dilemma, what is the dominant strategy for each player?

  1. Cooperate, because mutual cooperation gives the best collective outcome
  2. Defect, because it yields a better payoff regardless of what the other player does
  3. Randomize between cooperating and defecting
  4. Wait and see what the other player does before deciding
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The correct answer is B. A dominant strategy is one that gives a higher payoff no matter what the other player chooses. In the prisoner's dilemma, defecting is better for you whether the other player cooperates (you go free instead of serving 1 year) or defects (you serve 5 years instead of 10). This is precisely the paradox: both players have a dominant strategy to defect, yet mutual defection is worse for both than mutual cooperation (A). Randomizing (C) is not necessary when a dominant strategy exists, and waiting (D) is not possible in a simultaneous game.

Concept Tested: Dominant Strategy / Prisoner's Dilemma

3. George Akerlof's "market for lemons" describes which economic problem?

  1. Moral hazard --- people take excessive risks when insured
  2. Adverse selection --- information asymmetry drives good products out of the market
  3. Public goods --- free-riding reduces supply of shared resources
  4. Externalities --- costs imposed on third parties not involved in a transaction
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The correct answer is B. Akerlof showed that when sellers know the quality of their product but buyers do not, buyers offer a price reflecting average quality. Sellers of good products, who cannot get a fair price, withdraw from the market. This leaves only low-quality products ("lemons"), which is adverse selection --- the asymmetry of information systematically selects the wrong types into the market. Moral hazard (A) concerns hidden actions after a deal, not hidden information before one.

Concept Tested: Adverse Selection / Information Asymmetry

4. Two chai stalls on a beach both end up at the exact midpoint, even though spreading apart would be better for customers. This clustering illustrates:

  1. Market failure due to externalities
  2. A Nash equilibrium in spatial competition
  3. The sunk cost fallacy
  4. Diminishing marginal returns
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The correct answer is B. This is Hotelling's model of spatial competition. Each stall has an incentive to move toward the center to capture more customers, and neither can improve by moving once both are at the midpoint. The clustering is a Nash equilibrium --- stable, but not optimal for consumers. It explains why competing businesses (phone shops, dhabas, coaching centers) often cluster together rather than spreading out.

Concept Tested: Nash Equilibrium / Strategic Interaction

5. After buying comprehensive car insurance, a driver becomes less careful about locking the car. This is an example of:

  1. Adverse selection
  2. Bounded rationality
  3. Moral hazard
  4. Loss aversion
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The correct answer is C. Moral hazard occurs when a party changes their behavior after a transaction because they no longer bear the full cost of their actions. With insurance, the cost of a theft shifts partially to the insurer, reducing the driver's incentive to be cautious. This is why insurance policies include deductibles --- to keep some "skin in the game." Adverse selection (A) would be if reckless drivers were more likely to buy insurance in the first place. Bounded rationality (B) and loss aversion (D) describe cognitive limitations, not post-transaction behavioral changes.

Concept Tested: Moral Hazard

6. In India's 2G spectrum scandal, the government allocated valuable telecom licenses through an opaque first-come, first-served process rather than a competitive auction. This allocation method suffered from:

  1. Only moral hazard
  2. Only adverse selection
  3. Both information asymmetry and moral hazard
  4. Neither --- the method was efficient but politically unpopular
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The correct answer is C. The scandal involved both problems. Information asymmetry: companies had better information about the true market value of spectrum than the non-transparent allocation process revealed, allowing them to acquire licenses far below their worth. Moral hazard: the officials designing the allocation process benefited personally from relationships with recipient companies while the cost (estimated at up to Rs 1.76 lakh crore in lost revenue) was borne by the public. The Supreme Court's cancellation of 122 licenses and the shift to auction-based allocation addressed both problems.

Concept Tested: Information Asymmetry / Moral Hazard / Institutions

7. In A Beautiful Mind, Nash's bar scene insight is that if all his friends pursue the same woman, they all lose. The stable outcome requires each person to adjust their strategy based on others' choices. What does the film's bar scene illustrate about the difference between individual and strategic optimization?

  1. Individual optimization always leads to the best collective outcome
  2. Strategic interaction means your best choice depends on others' choices --- optimizing in isolation can make everyone worse off
  3. Cooperation is always superior to competition
  4. Game theory only applies to situations involving romantic relationships
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The correct answer is B. The bar scene's core lesson is that in strategic settings, the best response for each player depends on what others are doing. If everyone independently pursues their top individual choice, the result can be collectively worse than if they had considered each other's actions. This is the fundamental insight of Nash equilibrium. Option A is the opposite of what the scene shows. Option C is too strong --- cooperation is sometimes but not always better (and can be illegal if firms collude). Option D is obviously incorrect --- the scene uses a social setting to illustrate a universal principle.

Concept Tested: Nash Equilibrium / Strategic Interaction

8. Farmers in Punjab continue to over-extract groundwater even though everyone would benefit from collective restraint. Each farmer reasons: "If I conserve, my neighbors will pump more, and I lose the water I saved." This situation is best analyzed as:

  1. A market with perfect competition
  2. A principal-agent problem
  3. A prisoner's dilemma with many players
  4. An example of loss aversion
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The correct answer is C. Each farmer's dominant strategy is to pump aggressively (defect), regardless of what others do --- conserving only benefits others at one's own expense. When all farmers follow this logic, the aquifer is depleted, leaving everyone worse off. This is the multi-player prisoner's dilemma (also called a "tragedy of the commons"). The Nash equilibrium is over-extraction, even though mutual restraint would be collectively superior. Solving it requires changing the game through regulation, pricing, or enforceable community agreements.

Concept Tested: Prisoner's Dilemma / Cooperation

9. A shopkeeper in a tourist market quotes Rs 3,000 for a leather bag. A tourist, who has no idea of the fair price, counters with Rs 1,500. Both the initial quote and the counter-offer are likely influenced by:

  1. The endowment effect --- the shopkeeper overvalues goods they own
  2. The anchoring heuristic --- the first number stated disproportionately influences subsequent judgments
  3. Adverse selection --- the tourist cannot tell good leather from bad
  4. Nash equilibrium --- both players are playing their best response
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The correct answer is B. The anchoring heuristic describes the tendency to rely heavily on the first piece of information encountered. The shopkeeper's opening price of Rs 3,000 serves as an anchor that pulls the tourist's counter-offer upward --- even if the bag's true value is much lower, the tourist's "low" counter of Rs 1,500 is still anchored to the shopkeeper's high starting point. The endowment effect (A) could play a minor role but does not explain the specific price dynamics. Adverse selection (C) is about hidden quality, and while Nash equilibrium (D) could describe the bargaining outcome, the question asks about the cognitive mechanism shaping the bids, not the equilibrium outcome.

Concept Tested: Heuristics / Anchoring / Bounded Rationality

10. Consider two countries deciding whether to reduce carbon emissions. If both reduce, the planet benefits and each country bears moderate costs. If neither reduces, climate change worsens and both suffer. If one reduces while the other does not, the reducing country bears costs while the other free-rides. A critic argues that a binding international agreement is unnecessary because rational countries will cooperate voluntarily. Evaluate this claim.

  1. The critic is correct --- rational countries will see that cooperation benefits everyone and voluntarily reduce emissions
  2. The critic is wrong --- this is a prisoner's dilemma where the Nash equilibrium is non-cooperation, so binding agreements or enforcement mechanisms are needed to sustain emissions reductions
  3. The critic is correct --- repeated interaction between countries guarantees cooperation over time
  4. The critic is wrong --- but only because countries are irrational and do not understand their own interests
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The correct answer is B. The climate change game has the structure of a prisoner's dilemma: each country's dominant strategy is to not reduce emissions (free-ride on others' reductions), and the Nash equilibrium is insufficient action, even though all countries would benefit from mutual cooperation. The fact that cooperation benefits everyone (A) is precisely the paradox --- mutual cooperation is better, but it is not a Nash equilibrium because each country can gain by deviating. Repeated interaction (C) can help sustain cooperation but does not guarantee it, especially when the number of players is large and monitoring is difficult. The problem (D) is not irrationality but rather the structural incentives of the game. This is why international climate agreements require enforcement, monitoring, and mechanisms to punish free-riding.

Concept Tested: Prisoner's Dilemma / Cooperation / Institutions

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