Economics

Michael Parkin

Chapter 20

Uncertainty and Information - all with Video Answers

Educators

Chapter Questions

Problem 1

The figure shows Lee's utility of wealth curve.
Lee is offered a job as a salesperson in which there is a 50 percent chance that she will make $\$ 4,000$ a month and a 50 percent chance that she will make nothing.
a. What is Lee's expected income from taking this job?
b. What is Lee's expected utility from taking this job?
c. How much would another firm have to offer Lee with certainty to persuade her not to take the risky sales job?
d. What is Lee's cost of risk?

Luis Fernando Olloqui Regalado

Luis Fernando Olloqui Regalado

Numerade Educator

Problem 2

Use the following data to work Larry lives in a neighborhood in which 20 percent of the cars are stolen every year. Larry's car, which he parks on the street overnight, is worth $\$ 20,000$ (This is Larry's only wealth.) The table shows Larry's utility of wealth schedule.
If Larry cannot buy auto theft insurance, what is his expected wealth and his expected utility?

Luis Fernando Olloqui Regalado

Luis Fernando Olloqui Regalado

Numerade Educator

Problem 3

Use the following data to work Larry lives in a neighborhood in which 20 percent of the cars are stolen every year. Larry's car, which he parks on the street overnight, is worth $\$ 20,000$ (This is Larry's only wealth.) The table shows Larry's utility of wealth schedule.
High-Crime Auto Theft, an insurance company, offers to sell Larry insurance at $\$ 8,000$ a year and promises to provide Larry with a replacement car worth $\$ 20,000$ if his car is stolen. Is Larry willing to buy this insurance? If not, is he willing to pay $\$ 4,000$ a year for such insurance?

Luis Fernando Olloqui Regalado

Luis Fernando Olloqui Regalado

Numerade Educator

Problem 4

Suppose that there are three national soccer leagues: Time League, Goal Difference League, and Bonus for Win League. The leagues are of cqual quality, but the players are paid differently. Players in the Time League are paid by the hour for time spent practicing and playing. Players in the Goal Difference League are paid an amount that depends on the goals scored by the team minus the goals scored against it. Players in the Bonus for Win League are paid one wage for a loss, a higher wage for a tie, and the highest wage of all for a win.
a. Describe the predicted differences in the quality of the games played by each of the leagues.
b. Which league is the most attractive to players?
c. Which league will generate the largest profits?

Luis Fernando Olloqui Regalado

Luis Fernando Olloqui Regalado

Numerade Educator

Problem 5

You can't buy insurance against the risk of being sold a lemon. Why isn't there such a market? How does the market provide a buyer with some protection against being sold a lemon? What are the main ways in which markets overcome the lemons problem?

Luis Fernando Olloqui Regalado

Luis Fernando Olloqui Regalado

Numerade Educator

Problem 6

I have no clue what my colleagues make and I consider my salary my own business. It turns out that could be a huge mistake. What if employers made all employee salaries known? If you think about it, who is served by all the secrecy? Knowing what other workers make might be more ammunition to gun for a raise.
Explain why a worker might be willing to pay for the salary information of other workers.

Luis Fernando Olloqui Regalado

Luis Fernando Olloqui Regalado

Numerade Educator

Problem 7

What are Jimmy's and Zenda's expected utilities from a bet that gives them a 50 percent chance of having a wealth of $\$ 600$ and a 50 percent chance of having nothing?

Luis Fernando Olloqui Regalado

Luis Fernando Olloqui Regalado

Numerade Educator

Problem 8

a. Calculate Jimmy's and Zenda's marginal utility of wealth schedules.
b. Who is more risk averse, Jimmy or Zenda? How do you know?

Luis Fernando Olloqui Regalado

Luis Fernando Olloqui Regalado

Numerade Educator

Problem 9

Suppose that Jimmy and Zenda cach have $\$ 400$ and are offered a business investment opportunity that involves committing the entire $\$ 400$ to the project. The project could return $\$ 600$ (a profit of $\$ 200$ ) with a probability of 0.85 or $\$ 200$ (a loss of $\$ 200$ ) with a probability of 0.15 Who goes for the project and who hangs on to the initial $\$ 400 ?$
Use the following information to work Problems 10 to 12
Two students, Jim and Kim, are offered summer jobs managing a student house-painting business. There is a 50 percent chance that either of them will be successful and end up with $\$ 21,000$ of wealth to get them through the next school year. But there is also a 50 percent chance that either will end up with only $\$ 3,000$ of wealth. Each could take a completely safe but back-breaking job picking fruit that would leave them with a guaranteed $\$ 9,000$ at the end of the summer. The table in the next column shows Jim's and Kim's utility of wealth schedules.

Luis Fernando Olloqui Regalado

Luis Fernando Olloqui Regalado

Numerade Educator

Problem 10

Does anyone take the painting job? If so, who takes it and why? Does anyone take the job picking fruit? If so, who takes it and why?

Luis Fernando Olloqui Regalado

Luis Fernando Olloqui Regalado

Numerade Educator

Problem 11

In Problem $10,$ what is each student's maximized expected utility? Who has the larger expected wealth? Who ends up with the larger wealth at the end of the summer?

Luis Fernando Olloqui Regalado

Luis Fernando Olloqui Regalado

Numerade Educator

Problem 12

In Problem $10,$ if one of the students takes the risky job, how much more would the fruitpicking job have needed to pay to attract that student?

Luis Fernando Olloqui Regalado

Luis Fernando Olloqui Regalado

Numerade Educator

Problem 13

Use the following table, which shows Chris's utility of wealth schedule, to work Problems 13 and 14 Chris's wealth is $\$ 5,000$ and it consists entirely of her share in a risky ice cream business. If the summer is cold, the business will fail, and she will have no wealth. Where Chris lives there is a 50 percent chance each year that the summer will be cold.
If Chris cannot buy cold-summer insurance, what is her expected wealth and what is her expected utility?

Luis Fernando Olloqui Regalado

Luis Fernando Olloqui Regalado

Numerade Educator

Problem 14

Use the following table, which shows Chris's utility of wealth schedule, to work Chris's wealth is $\$ 5,000$ and it consists entirely of her share in a risky ice cream business. If the summer is cold, the business will fail, and she will have no wealth. Where Chris lives there is a 50 percent chance each year that the summer will be cold.
Business Loss Recovery, an insurance company, is willing to sell Chris cold-summer insurance at a price of $\$ 3,000$ a year and promises to pay her $\$ 5,000$ if the summer is cold and the business fails. Is Chris willing to buy this loss insurance? If she is, is she willing to pay $\$ 4,000$ a year for it?

Luis Fernando Olloqui Regalado

Luis Fernando Olloqui Regalado

Numerade Educator

Problem 15

Use the following information to work. Larry has a good car that he wants to sell; Harry has a lemon that he wants to sell. Each knows what type of car he is selling. You are looking at used cars and plan to buy one.
If both Larry and Harry are offering their cars for sale at the same price, from whom would you most want to buy, Larry or Harry, and why?

Luis Fernando Olloqui Regalado

Luis Fernando Olloqui Regalado

Numerade Educator

Problem 16

Use the following information to work. Larry has a good car that he wants to sell; Harry has a lemon that he wants to sell. Each knows what type of car he is selling. You are looking at used cars and plan to buy one.
If you made an offer of the same price to Larry and Harry, who would sell to you and why? Describe the adverse selection problem that arises if you offer the same price to Larry and Harry.

Luis Fernando Olloqui Regalado

Luis Fernando Olloqui Regalado

Numerade Educator

Problem 17

Use the following information to work. Larry has a good car that he wants to sell; Harry has a lemon that he wants to sell. Each knows what type of car he is selling. You are looking at used cars and plan to buy one.
How can Larry signal that he is selling a good car so that you are willing to pay Larry the price that he knows his car is worth, and a higher price than what you are willing to offer Harry?

Luis Fernando Olloqui Regalado

Luis Fernando Olloqui Regalado

Numerade Educator

Problem 18

Pam is a safe driver and Fran is a reckless driver. Each knows what type of driver she is, but no one else knows. What might an automobile insurance company do to get Pam to signal that she is a safe driver so that it can offer her insurance at a lower premium than it offers to Fran?

Alexander Cheng

Alexander Cheng

Numerade Educator

Problem 19

Why do you think it is not possible to buy insurance against having to put up with a low-paying, miserable job? Explain why a market in insurance of this type would be valuable to workers but unprofitable for an insurance provider and so would not work.

EA

Erwin Antoni

Numerade Educator

Problem 20

We pride ourselves on being the only species that understands the concept of risk, yet we have a confounding habit of worrying about mere possibilities while ignoring probabilities, building barricades against perceived dangers while leaving ourselves exposed to real ones: $20 \%$ of all adults still smoke; nearly $20 \%$ of drivers and more than $30 \%$ of back seat passengers don't use seat belts; two thirds of us are overweight or obese. We dash across the street against the light and build our homes in hurricane prone areas - and when they're demolished by a storm, we rebuild in the same spot.
Explain how "worrying about mere possibilities while ignoring probabilities" can result in people making decisions that not only fail to satisfy social interest, but also fail to satisfy self-interest.

Gaurav Kalra

Numerade Educator

Problem 21

We pride ourselves on being the only species that understands the concept of risk, yet we have a confounding habit of worrying about mere possibilities while ignoring probabilities, building barricades against perceived dangers while leaving ourselves exposed to real ones: $20 \%$ of all adults still smoke; nearly $20 \%$ of drivers and more than $30 \%$ of back seat passengers don't use seat belts; two thirds of us are overweight or obese. We dash across the street against the light and build our homes in hurricane prone areas - and when they're demolished by a storm, we rebuild in the same spot.
How can information be used to improve people's decision making?

Nick Johnson

Numerade Educator

Problem 22

After you have studied Economics in the News on
PP. $482-483,$ answer the following questions.
a. What information do accurate grades provide that grade inflation hides?
b. If grade inflation became widespread in high schools, colleges, and universities, what new arrangements do you predict would emerge to provide better information about student ability?
c. Do you think grade inflation is in anyone's self-interest? Explain who benefits and how they benefit from grade inflation.
d. How do you think grade inflation might be controlled?

Alejandro Ruiz

Numerade Educator

Problem 23

In the light of accumulating bad loans, some banks, including Indian Bank, have resorted to utilizing the services of private detective agencies to track the whereabouts of borrowers who have not repaid loans. Once the process of recovery commences, the bank looks to attach other assets of the borrower, if the security provided is lower than the loan amount. Here is where the role of the detective comes into play. The detective, on the basis of primary leads such as the address provided by the borrower in the loan documents and secondary leads such as voter ID, tracks the whereabouts of the borrower for the bank.

Source: The Times of India, November 20,2014
a. Explain the role asymmetric information can play in interest rates charged by banks.
b. What adverse selection problem exists if a bank charges its borrowers a higher interest rate?
c. What will determine whether a bank should actually hire a detective to track the borrowers or not?

Nick Johnson

Numerade Educator