Chapter 2
1.
a. In this particular insurance market, one would not expect asymmetric
information to be much of a problem – the probability of a hurricane is
common knowledge. Moral hazard could be an issue – people are more
likely to build near a beach if they have hurricane insurance. Still, one would
expect the market for hurricane insurance to operate fairly efficiently.
b. There is substantial asymmetric information in the markets for medical
insurance for consumers and also malpractice insurance for physicians. For
efficient consumption, the price must be equal to the marginal cost, and the
effect of insurance may be to reduce the perceived price of medical care
consumption. That would lead to consumption above the efficient level.
Because of the roles of regulation, insurance, taxes, and the shifting of costs
from the uninsured to the insured, there is little reason to expect the market
to be efficient.
c. In the stock market, there is good information and thousands of buyers and
sellers. We expect, in general, efficient outcomes.
d. From a national standpoint, there is a good deal of competition and
information with regards to MP3 players and music. The outcome will likely
be efficient for MP3 players and music. However, some firms might exercise
some market power through high brand awareness and proprietary
downloading systems.
e. The private market allocation is likely inefficient without government
intervention. Student loan markets may suffer from asymmetric
information – the student knows better than the lender whether he will
repay the loan or default on it, a form of adverse selection. Government
intervention does not “solve” the adverse selection problem in this case
(because participation in the student loan program is not compulsory), but it
may create a market that would not exist without intervention.
f. The market for housing is likely to be relatively efficient. Some inefficiencies
may exist, such as asymmetric information—the seller knows more about
the house than the buyer—and differentiated products. But, the market has
developed to mitigate these inefficiencies. For example, a buyer can employ
a home inspector to help him understand more about the quality of the
home. Also, a large number of homes on the market increases competition.
, 2. No. The marginal rate of substitution of beer for pizza (MRS) is 2 for Hamlet and 3 for
Ophelia. This violates the necessary condition for a Pareto efficient allocation.
3.
a. Social indifference curves are straight lines with slope of –1. As far as society is
concerned a “util” to Augustus is equivalent to a “util” to Livia.
,b. Social indifferences are straight lines with slope of –2. This reflects the fact that society
values a “util” to Augustus twice as much as a “util” to Livia.
c.
, 4. Point a represents an equal allocation of water, but it is not efficient because there is no
tangency. Point b is an efficient allocation (but not the only one).
AD: 1) the dashed line is positioned at the halfway point on the horizontal axis.
2) point b is a tangency
If Americans have a higher MRSwb than Canadians, then there are gains for residents of
both countries if Canada exports water to the U.S. in exchange for bread.
5. The marginal rate of transformation between foreign and domestic movies depends on the
ratio of their prices before taxes and subsidies. Because of the wedge created by the taxes
and subsidies, the two price ratios are different. Therefore, the marginal rate of
substitution and marginal rate of transformation are not equal, and the allocation of
resources is inefficient.
6. a. If John had one loaf of bread, he would be willing to give up 10 kilos of cheese for an
additional loaf of bread. If Marsha had one loaf of bread, she would be willing to
give up 5 kilos of cheese for an additional loaf of bread.
b. The initial allocation at point a in the Edgeworth box is not Pareto efficient because
John is willing to given up 2/3 of a kilo of cheese for an extra loaf of bread while
1.
a. In this particular insurance market, one would not expect asymmetric
information to be much of a problem – the probability of a hurricane is
common knowledge. Moral hazard could be an issue – people are more
likely to build near a beach if they have hurricane insurance. Still, one would
expect the market for hurricane insurance to operate fairly efficiently.
b. There is substantial asymmetric information in the markets for medical
insurance for consumers and also malpractice insurance for physicians. For
efficient consumption, the price must be equal to the marginal cost, and the
effect of insurance may be to reduce the perceived price of medical care
consumption. That would lead to consumption above the efficient level.
Because of the roles of regulation, insurance, taxes, and the shifting of costs
from the uninsured to the insured, there is little reason to expect the market
to be efficient.
c. In the stock market, there is good information and thousands of buyers and
sellers. We expect, in general, efficient outcomes.
d. From a national standpoint, there is a good deal of competition and
information with regards to MP3 players and music. The outcome will likely
be efficient for MP3 players and music. However, some firms might exercise
some market power through high brand awareness and proprietary
downloading systems.
e. The private market allocation is likely inefficient without government
intervention. Student loan markets may suffer from asymmetric
information – the student knows better than the lender whether he will
repay the loan or default on it, a form of adverse selection. Government
intervention does not “solve” the adverse selection problem in this case
(because participation in the student loan program is not compulsory), but it
may create a market that would not exist without intervention.
f. The market for housing is likely to be relatively efficient. Some inefficiencies
may exist, such as asymmetric information—the seller knows more about
the house than the buyer—and differentiated products. But, the market has
developed to mitigate these inefficiencies. For example, a buyer can employ
a home inspector to help him understand more about the quality of the
home. Also, a large number of homes on the market increases competition.
, 2. No. The marginal rate of substitution of beer for pizza (MRS) is 2 for Hamlet and 3 for
Ophelia. This violates the necessary condition for a Pareto efficient allocation.
3.
a. Social indifference curves are straight lines with slope of –1. As far as society is
concerned a “util” to Augustus is equivalent to a “util” to Livia.
,b. Social indifferences are straight lines with slope of –2. This reflects the fact that society
values a “util” to Augustus twice as much as a “util” to Livia.
c.
, 4. Point a represents an equal allocation of water, but it is not efficient because there is no
tangency. Point b is an efficient allocation (but not the only one).
AD: 1) the dashed line is positioned at the halfway point on the horizontal axis.
2) point b is a tangency
If Americans have a higher MRSwb than Canadians, then there are gains for residents of
both countries if Canada exports water to the U.S. in exchange for bread.
5. The marginal rate of transformation between foreign and domestic movies depends on the
ratio of their prices before taxes and subsidies. Because of the wedge created by the taxes
and subsidies, the two price ratios are different. Therefore, the marginal rate of
substitution and marginal rate of transformation are not equal, and the allocation of
resources is inefficient.
6. a. If John had one loaf of bread, he would be willing to give up 10 kilos of cheese for an
additional loaf of bread. If Marsha had one loaf of bread, she would be willing to
give up 5 kilos of cheese for an additional loaf of bread.
b. The initial allocation at point a in the Edgeworth box is not Pareto efficient because
John is willing to given up 2/3 of a kilo of cheese for an extra loaf of bread while
