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Terms in this set (386)

2. Individual Problems 2-2
Suppose you recently sold your used car. Assume that no new production was involved in this transaction.
Wealth was created because the buyer's willingness to pay wasequal to the value of your willingness to sell.
Points:
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Explanation:
Wealth is created when assets move from lower- to higher-valued uses. In the context of a transaction, a buyer purchases an item only if the price she must pay for it is at or below the value she places on it (i.e., the maximum amount she would be willing to pay). Similarly, a seller sells an item only if the price he receives for it is at or above the minimum price he would be willing to sell it for. This implies that, as long as the seller's value (or "bottom line") is lower than the buyer's value (her maximum willingness to pay or "top dollar"), then a wealth-creating transaction is possible. If the transaction occurs, that means the price was between the seller's bottom line and the buyer's top dollar, and both parties are left better off.
Suppose you sold the car for $36,000.
If the minimum price, or "bottom line," you would accept for the car is $16,000 and the most the buyer is willing to pay is $40,000, then the seller surplus is$4,000.00and the buyer surplus is-$24,000.00. The total surplus created by the transaction is$20,000.00
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Explanation:
The difference between the price and the seller's value is called seller surplus. In this case, seller surplus is $36,000−$16,000=$20,000$36,000−$16,000=$20,000. Similarly, buyer surplus is buyer's value minus the price. In this case, buyer surplus is $40,000−$36,000=$4,000$40,000−$36,000=$4,000. Total surplus, or total gains from trade, from this transaction is the sum of buyer surplus and seller surplus. Summing buyer surplus and seller surplus yields $4,000+$20,000=$24,000$4,000+$20,000=$24,000.
The consumer will purchase sessions so long as their willingness to pay for a session is higher than the price. At a price of $66.00 per session, the consumer's willingness to pay for the first twosessions is below the price required to pay for each session. So the consumer purchases that session. The third session, however, would cost the consumer more than their willingness to pay for it ($60), so the consumer would not purchase that session.
Consumer surplus is the difference between willingness to pay and the price actually paid, for all units consumed. In this case, since the consumer demanded 2 sessions, consumer surplus is ($84−$66.00)+($72−$66.00)=$24.00$84−$66.00+$72−$66.00=$24.00.
Producer surplus is the difference between the price received by the producer and the cost of producing that unit, for all units sold. In this case, since the studio supplied 2 sessions, producer surplus is ($66.00−$12)+($66.00−$12)=$108.00$66.00−$12+$66.00−$12=$108.00.



Once the consumer has paid the subscription price in full, the marginal cost to the consumer of each session falls to zero. Thus, after paying the subscription price, the consumer will demand all 6 sessions since their willingness to pay for each of those 6 sessions is greater than 0. The total value the consumer places on all 6 sessions is $84+$72+$60+$48+$36+$24=$324$84+$72+$60+$48+$36+$24=$324. Given the total cost of the subscription, $243.00, the consumer surplus from this pricing strategy is $324−$243.00=$81.00$324−$243.00=$81.00.
The producer surplus under these same conditions is calculated as the total revenue generated by the strategy, less the total cost. Since each session costs $12, the total cost under this strategy is 6×$12=$72.006×$12=$72.00. Given the revenue gained from this subscription, $243.00, the producer surplus is $243.00−$72.00=$171.00$243.00−$72.00=$171.00.
Since this consumer enjoys a larger consumer surplus, the consumer will likely choose the subscription rather than paying $66.00 per session.
accepting
71
120
accepting
120
71
low

If employer A offered a high salary, you would accept it, since accepting it yields a higher payoff (120) than rejecting it (0). Additionally, if employee A offered a low salary, you would also accept it, since the payoff of accepting the low offer (71) is greater than the payoff of rejecting it (0). In short, you would accept any offer.
With the knowledge that you will accept the offer, regardless of whether it is high or low, employer A will make her decision to maximize her own payoff. If employer A offers a high salary, she will get a payoff of 71 when you accept. On the other hand, making a low salary offer will yield a payoff of 120 when you accept. Thus, it is more profitable for employer A to make a low offer. The ordering of the game gives employer A a first-mover's advantage and the equilibrium path is {low, accept}.

False

If employer A offered a high salary, you would accept it, since accepting it yields a higher payoff (120) than rejecting it (0). Additionally, if employee A offered a low salary, you would also accept it, since the payoff of accepting the low offer (71) is greater than the payoff of rejecting it (0). In short, you would accept any offer.
With the knowledge that you will accept the offer, regardless of whether it is high or low, employer A will make her decision to maximize her own payoff. If employer A offers a high salary, she will get a payoff of 71 when you accept. On the other hand, making a low salary offer will yield a payoff of 120 when you accept. Thus, it is more profitable for employer A to make a low offer. The ordering of the game gives employer A a first-mover's advantage and the equilibrium path is {low, accept}.
For each decision in the following table, calculate and enter the expected error cost of that decision.
Reality
Good Fit Bad Fit Expected Error Cost
Decision p=0.2 p=0.8
Hire Cost: 0 Cost: $400 $320.00 Do Not Hire Cost: $400 Cost: 0 $80.00


Not Hire

When hiring an applicant, the HR department can never know for sure whether that individual is a good fit. Only after that applicant begins working as an employee can the HR department determine whether that individual was a good fit or not. Because "guessing wrong" results in an error cost, the decision to hire or not comes with a possible error cost. If the HR department hires an applicant, the company incurs a cost of $400 with probability 0.8 and no cost otherwise. Thus, the expected error cost is 0.8×$400+0.2×0=$3200.8×$400+0.2×0=$320. On the other hand, not hiring an applicant comes with the expected error cost of failing to hire an employee who is a good fit, 0.2×$400+0.8×0=$800.2×$400+0.8×0=$80.

From your previous calculations, you know that hiring an applicant comes with an expected error cost of $320, while not hiring an applicant comes with an expected error cost of $80. Because hiring an applicant comes with a lower expected error cost than not hiring the applicant, the HR department should not hire the applicant to minimize expected error costs.
In reality, the Type II error of hiring a "bad fit" is more likely to be recognized and discovered, so the HR manager will "shade" his or her decisions to try to avoid hiring these types of workers. This will likely cause him or her to commit more Type I errors, resulting in an increased likelihood of failing to hire applicants who are "good fits."
Adverse Selection

higher

False

Adverse selection arises from information asymmetry, whereby one party to a transaction has more, or better, information than another, affecting market participation.
In this case, at a price of 2% of the product price, the extended warranty is likely to be more appealing to customers who are inherently less careful and more likely to misuse the product. While the failure rate of products sold to people without the warranty will likely be 2%, the failure rate of products purchased with the extended warranty will likely be higher, given the types of customers who are likely to purchase the warranty. Because the company does not know which customers will misuse the product, there is an information asymmetry, which gives rise to adverse selection.

Both moral hazard and adverse selection could cause the failure rate (and the claim rate) to be higher than 2%. The adverse selection problem is that high-risk individuals are more likely than low-risk individuals to purchase the warranty, pushing the failure rate above 2%. The moral hazard problem is that, once people have the warranty, they're likely to behave in ways that increase the probability that a claim on the warranty will be made. To avoid losing money from the sale of the warranty, you would want to price the extended warranty higher than 2% of the product price.
For example, if moral hazard or adverse selection causes the failure rate to rise to 3%, then the expected cost of servicing the warranty is 3%×$100=$33%×$100=$3. If you keep the price of the warranty at 2% of the product price, the revenue from the warranty is 2%×$100=$22%×$100=$2. On average, you would lose money from offering the warranty at 2% of the product price.
Adverse Selection

Moral Hazard

Moral Hazard

Moral hazard and adverse selection often offer competing explanations for the same observed behavior. While both problems are caused by information asymmetry, it is the type of information that is hidden that distinguishes moral hazard and adverse selection. In particular, moral hazard is caused by hidden actions by individuals, whereas adverse selection is caused by hidden information regarding characteristics of different individuals. Both problems can be addressed by eliminating the information asymmetry that gives rise to them.
In this case, the insurance company does not have information about your friend's health or general lifestyle.
The exact activities that your friend will undertake after purchasing insurance are hidden actions that are unknown to the company at the time of purchase. If the insurance company believes that having insurance will incentivize your friend to engage in risky behavior (since any resulting injuries would be at least partially covered), then the insurance company believes that moral hazard is present. To combat this, insurance companies may charge a higher premium to compensate for the risk. This could explain your friend's high premiums.
The problem of adverse selection would arise because the insurance company cannot perfectly determine whether your friend is healthy or unhealthy. To compensate for the possibility that insurees are high-risk, the insurance company must charge a relatively high premium or adjust other aspects of the policy. However, this will cause healthy customers to seek health insurance elsewhere or refuse to purchase insurance at all, while less healthy customers will continue to seek health insurance at this company. As a result, the company may assume that most potential and existing customers are unhealthy and charge even higher premiums. This also could explain your friend's high premiums.

Moral hazard deals with hidden actions, as opposed to hidden information about the characteristics of individuals and goods. Thus, a contract that withholds benefits in cases with incidents related to risky behavior would remove the liability to the company resulting from incidents involving risky behavior. This would help solve the problem of moral hazard. Without the need to consider these risky behaviors, the company can offer insurance to your friend at a lower premium and still make a profit.