Answers to Review Questions

Chapters 11-12

Extra Stuff . . Chapter 11 . . Chapter12

Chapter 11 Efficiency

Exploring Efficiency

1. The final test for Economics 98 is at 3:00 on the last Friday before vacation starts. Barb Bright suggests to Professor Smith that because it does not matter to him when the test is held, it would be economically efficient for the class to pay him $20.00 and he could reschedule the test for Wednesday evening. The entire class agrees with Barb that this would be a good idea.

a) Is Ms. Bright right that this move would increase economic efficiency?
She is correct.

b) If she is correct that such a transaction would improve economic efficiency, why would this transaction violate the rules of virtually all colleges?
It is too easy to have similar transactions that do nasty things, such as professors selling grades. Rather The potential for abuse is large. If the professors can accept money for changing test times, for what else will the begin accepting money? The administration could monitor on a case-by-case basis, but the cost of such monitoring is large. Hence, the solution is simply to ban all exchanges of money between students and professors.

(We can find a similar situation in the way police are required to treat prisoners. By putting restrictions on what the police can do, we sometimes let guilty people go free. However, by not putting restrictions on what the police can do, we invite a lot of police misconduct.)

2. Suppose that John thinks one banana is worth four apples and Sue thinks one banana is worth two apples. If they both have apples and bananas, what trade will take place?
Yes. For John bananas are more valuable than for Sue. At a price of one banana equals three apples, Sue would sell bananas and John would buy them, and both would be better off.

3. If some of the concerns of efficiency sound familiar, it may be because we have met them before, hiding under different concepts. In fact, one way to explore efficiency is with producer and consumer surplus.

Assume that the market for Windies is made up of the fourteen people shown in the following table. Seven do not have a Windie, and the maximum price they are willing to pay is shown in the first two columns. (Alice is willing to pay up to $20 to get a Windie.) Seven people have a Windie, and the lowest price they will accept to sell their Windie is given in the last two columns. (If Holly is offered $4.00 or more, she will sell.)

Willingness to Pay


Minimum Acceptable Price








a) Ignore the sellers for a minute and consider only the buyers. If only one item is available and it is sold at auction, what price should it fetch?
A bit more than $15.00. Once the price exceeds $15, only Alice is left to bid.

b) Suppose that a price of $12.00 is established and all transactions must take place at this price. How many will be exchanged? Explain how a mutually beneficial trade could be made at a different price.
Only two would be bought, by Alice and Bill. However, there would be six offered for sale. One of the disappointed sellers would be willing to sell his item to Carol, who is willing to pay up to $11.00.

c) Suppose that a price of $5.00 is established and all transactions must take place at this price. How many will be exchanged? Explain how a mutually beneficial trade could be made at a different price.
There are six potential buyers, but only three willing sellers, so only three would be exchanged. Karen would be willing to sell at $7.00, and one of the disappointed buyers would be willing to accept that.

d) Find the price at which it is impossible for any mutually beneficial trade to be made at any other price once it is established.
At a price of $8.00 there are five willing buyers and five willing sellers.

e) What is the equilibrium price and quantity in this market?
At a price of $8.00, five will be sold.

f) At this equilibrium, compute total value to buyers, total revenue, consumer surplus, and producer surplus.
Total value to buyers = $20+$15+$11+$9+$8 = $63. Total revenue = 5*$8=40. Consumers' surplus = $63-$40=$23. Producers' surplus = ($8-$4)+$(8-$4)+$(8-$5)+$(8-$7)+$(8-$8)=$4+$4+$3+$1 +0 = $12. Total surplus = $23 + $12=$35.

g) Suppose the sellers collude so that Holly, Ingrid, and Jane agree to pay Karen $4.10 and Larry $3.10 to stay out of the market. Can they make enough extra with the higher price that will result to make these payments? What happens to consumer and producer surpluses? What happens t o the sum of consumer and producer surplus?
We will reduce the number of sellers to three. If only three are sold, the price will rise to $11.00. Holly, Ingrid and Jane gain a total of $9.00, which is enough to pay the $7.20 to Karen and Larry. They have $1.80 to split among themselves. Total surplus to sellers is ($11-$4)+($11-$4)+($11-$5)= $7 + $7 + $6 = $20. However, surplus to consumers is now ($20-$11) + ($15-$11) + ($11-$11) = $9 + $4 = $13. Total surplus has dropped from $35 to $33.

h) Suppose that Alice, Bill, Carol, and Dave pay Erin $1.10 to not buy. What happens to the price and to producer and consumer surpluses? Is this change good or bad? Explain.
We reduce buyers to 4, pushing down price to $7.00. Alice, Bill, Carol, and Dave each gain $1.00 in surplus, part of which is used to pay Erin. Holly, Ingrid, Jane, and Karen each lose $1.00 in surplus. In this case here, the marginal buyer and seller had no surplus, so eliminating them does not change the total. Normally, eliminating a seller or buyer by collusion will eliminate some surplus, as it did in part g.

i) Suppose that a government regulator sees this market and decrees that Nancy must sell to Alice (and Alice buy from Nancy), Mark and Bill must exchange, etc. If he pairs buyers and sellers in this way, the amount exchanged will be seven. Explain why this decree will be opposed by an economist.
The goal is not to maximize transactions. It is to get the items to those who value them most. Fred ends up with an item that he values at only $5.00, but we made Nancy give up the same item and she values it at $13.00.

4. Cuba is one of the poorest nations in the world. However, it produces a large number of athletes who capture Olympic medals. Is this athletic prowess an indication of success for the Cuban way of life, or is it a sign of folly and foolishness? Whatever position you take, argue your position in terms of the production-possibilities frontier.
Cuba devotes a large amount of resource into producing athletes, resource that could have been used to produce other goods and services. If having good athletes is more important than having good food or good roads, then they have made a good choice. If ample food and clothing are more important than good athletes, they have made a poor choice.

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Exploring Reservations about Efficiency

6. The concept of economic efficiency only makes sense if we think that we should take people's wants seriously. In other words, we should trust people to know what is best for themselves and to act in a way that will let them accomplish their goals. If we do not believe that, economic efficiency loses a lot of its appeal. (However, trying to find something else to replace it and that is not subject to even more serious problems is pretty much impossible.) Let us consider some possible objections to the notion that people know what is best for themselves.

Fun questions that call into question that people really are rational. If they are not, the normative basis of economic efficiency is undercut.

a) Steve is overweight and in his rational moments would like to reduce his intake of calories. However, he has little self control. When he sees junk food, he has an irresistible urge to eat until he is gorged, and then he feels very bad about his actions. When we value food for him, should we assign it the values that his rational self would assign it (low), or the value that his impulsive self would assign it (high)?

b) Some people have argued that people are easily manipulated by advertising and that hence all wants are artificial. This argument has been met with a variety of counter-arguments that need not concern us here. However, even if advertising is not as potent as some believe, the underlying assumption of most of it is that the route to happiness is to have things. If you believe that happiness is not found in the pursuit of things, and that most people believe that it is because they have been formed by a commercial culture, how seriously should you take economic efficiency as a goal for society?

c) The concept of the endowment effect (or status-quo) bias says that the value that people place on an object depends on whether they own it or not. Asking people what it is worth to get an item will yield different answers from asking them what it is worth to give it up. How can this pose a problem for the concept of economic efficiency? (Suppose we want to know what safety is worth. We can ask people how much they would pay to have their job made 1% safer, or we could ask how much we would have to pay them to make their jobs 1% less safe. We would get radically different answers. Which should we trust?)

7. Should the government protect people from themselves? The AP reported that a "man arrested at a friend's house when police broke up a New Year's Eve party has filed a lawsuit arguing that he had a constitutional right to get drunk on private property as long as he didn't cause a public disturbance." The police were following a state law that allowed them to lock up drunk people against their will for their own protection. The article noted that in the past the police had "been sued for failing to take people into protective custody who later died of alcohol poisoning." How does this tie into the question of whether people are rational or not? Does it raise any issues about economic efficiency? (Source: Chicago Tribune, July 10, 2005, Section 1, page 8.)

If people are rational, there is no reason for the government to protect them from themselves. If they are not always rational, there may be a reason to use government to protect them from themselves. Economics assumes people are rational in constructing its theories. Everything looks different if you reject that assumption.


Extra Stuff . . Chapter 11 . . Chapter12

Chapter 12 Problems of Information, Risk, and Exclusion

Exploring Screening and Signaling

1. Banks and savings and loan associations have often been accused of "redlining," that is, refusing to make any mortgage loans in certain segments of a city. Why might they redline?
Redlining could be a cheap way of screening. If people from certain areas of the city are more likely to default on loans than residents from other areas, an easy way to reduce defaulted loans is to avoid lending to the high-risk areas. Today, redlining is against the law in the United States.

2. In some transactions, there is a real risk that one party may cheat the other. People do not trust traveling salesmen, and there is good reason for that distrust. (Can you explain why traveling salesmen have a greater incentive to cheat customers than the local merchant?)
(Repeat business is not important for the traveling salesman, so the cost of cheating is low.)

As the Internet grew, it became possible for people all over the world to buy and sell from one another. However, commerce was limited by the cheating problem. How could you as a buyer trust someone who offered something for sale on the Internet? The author remembers buying and selling on usenet in the early 1990s, and dishonest sellers (and to a lesser extent, dishonest buyers) were a common and serious problem.

A solution to the cheating problem was discovered by the people who established the eBay auction site. Their solution made buying from and selling to individuals much less risky, and they were rewarded with a very successful company. Visit and see if you can discover the way they discovered that allows buyers and sellers, who are complete strangers, to have some confidence that they are dealing with people who will not cheat them. (Comment: the method they discovered is now routine on auction sites in which anyone can buy or sell.)
They implemented a feedback rating system. A seller with a feedback rating of 1000 has had at least 1000 transactions in which the other party to the transaction was happy. A person with a feedback rating of -1 has one more complaint than compliment, and it may be risky doing business with him. Feedback is reputation. It is hard to fake. A seller with a high feedback rating and an absence of negative comments will be able to sell at a higher price than a seller who no feedback.

2. In some transactions, there is a real risk that one party may cheat the other. People do not trust traveling salesmen, and there is good reason for that distrust. (Can you explain why traveling salesmen have a greater incentive to cheat customers than the local merchant?)

Traveling salesmen do not depend on repeat business so reputation does not matter. There are no penalties from customers for cheating them. So we expect business that relies on repeat customers to be more honest than those that do not. And if you live a while, you will experience that.

As the Internet grew, it became possible for people all over the world to buy and sell from one another. However, commerce was limited by the cheating problem. How could you as a buyer trust someone who offered something for sale on the Internet? The author remembers buying and selling on usenet in the early 1990s, and dishonest sellers (and to a lesser extent, dishonest buyers) were a common and serious problem.

A solution to the cheating problem was discovered by the people who established the eBay auction site. Their solution made buying from and selling to individuals much less risky, and they were rewarded with a very successful company. Visit and see if you can discover the way they discovered that allows buyers and sellers, who are complete strangers, to have some confidence that they are dealing with people who will not cheat them. (Comment: the method they discovered is now routine on auction sites in which anyone can buy or sell.)

The idea of feedback ratings overcame the information problems, and because the market had network externalities, it gave ebay the growth needed to become dominant.

3. Professor Langis has an unruly class of students who are debating whether or not there should be a final exam. After putting up with their whining for a while, he tells that class that he will let them vote on whether they will have a final. Six vote for a final, eight vote against, and four abstain. Professor Langis then announces that there is no need for a final. To compute the their final grades, he will add a bit to the scores of those who voted for the final, subtract a bit from those who voted against the final, and leave unchanged the scores of those who abstained. Those who voted against the final are outraged and accuse Professor Langis of being vindictive. However, the good professor tells them that he is just using the economics of signaling and that what he is doing is completely logical. Explain Professor Langis' reasoning.

The students are signaling how they expect to do on the final. If they do not want the final, they feel they have more to lose than to gain--they will probably drop, etc. (There may be other factors involved, and the idea could only be used once. I have not used it because I know the complaints would be fierce. But I am not sure that it would not be as accurate as a standard final.)

4. Quite a few years ago there was a television series, Columbo, about a police detective who solved murder cases in which the guilty individual was rich, successful, and sometimes famous. Columbo dressed poorly, drove an older car, and spoke in the way that suggested that he was not too bright. He usually solved the case when the guilty party underestimated him and made a mistake. How did this series illustrate the idea of ability signaling?

Columbo signaled that he was not too bright, encouraging the suspects to let down their guard.

5. In the software industry there used to be, and maybe still is, a distinction between the shirts and suits. The shirts where people who came to work in basically anything--often a tee shirt. (At one time, there was a male programmer at Apple Computer who regularly came to work in a dress.) The suits were people who had to dress nicely at work. What was the key to determining whether a person was a shirt or a suit?

If you do not interact with customers, you do not need to impress them. The computer programmer impresses people with his code, not his appearance, so he can wear whatever he wants, as long as he stays in his little cubicle.

6. Even most small colleges spend tens of thousands (or maybe even hundreds of thousands) of dollars on lawn care and landscaping. There is no compelling evidence that a prettier campus makes students study more or better. Why then do colleges make these expenditures?

My guess is that people from impressions about the quality of education from the quality of facilities

7. In the process of hiring, employers are legally forbidden to ask for certain sorts of personal information. For example, the law prohibits employers from asking applications about marital status. Economists who have studied signaling suspect that these laws have virtually no effect. Why?

If it is in the interest of the job applicants to give the information about a quality, the ones that have the right information will give it. Failure to provide the info will be interpreted as not having the quality. For example, if being single is an advantage in a job, those who are single should provide that information. If someone does not say they are single, the implication is that that person is not.

8. Many decades ago some economists were upset with the market concentration that brand names gave companies. They suggested that it might be a good idea to let other companies use the brand names of the dominant companies as a way to get more competition in the market. For example, the dried cereal market was and still is dominated by three or four firms. If other companies were able to market Kellogg Frosted Flakes, there would be more competition and presumably lower prices. Once economists developed the ideas of asymmetric information and signaling, these sorts of proposals disappeared. Why?

Brand names are a way of signaling quality, something that was not understood when economists were thinking about how to get rid of them.

Exploring Speculation

9. Five hundred years ago there was no one more unpopular in times of famine the speculator. When people were desperate for food, the speculators appeared, charging exorbitant prices for food. There was a widespread belief that it was immoral to profit from people in dire straits. However, economists do not share that common opinion--they argue that even if speculators are not very nice people, they are socially useful and good to have around. How can they defend people who make their living on the misfortunes of others?
(Here is an alternative way to get to ask this question. Several hundred years ago, the cities of the Netherlands were fighting Spain. Spain had blockaded one of the cities, food stockpiles were very low, and people were losing weight much faster than they wanted to. However, there were people who decided to take advantage of this desperate situation. They found ways to evade the blockade and bring food into the city, which they sold for whatever prices the market would bear. The city leaders were so outraged at this "war-profiteering" that they made it illegal. Was making war-profiteering illegal a wise decision or a foolish one? Explain.)

Without the speculator or blockade runner, prices would be even higher or shortages even more extreme.

10. a) Why is there no private insurance for unemployment?
Moral hazard and adverse selection are serious problems. Unemployment is something people have a lot of control over.
b) There is no market that insures against mentally or physically handicapped babies. Yet when people have children, there is a significant risk that they will have a child with such a handicap. How can you explain this gap in insurance coverage?
My explanation is that there would be some people who would intentionally damage their children to collect, and that behavior is unacceptable. To avoid the case of moral hazard, we do not offer this insurance. You may have another explanation.
c) In Britain, virtually all blood used in transfusions is donated. In the United States, much is purchased. Typical sellers include college students, slum dwellers, and drug addicts--all groups that can use the extra cash. The United States has had a much harder time keeping its blood supply free of infectious disease than has had Britain. Why?
Donor are unlikely to donate if they knows their blood is tainted. Donation takes place when people want to help others. People selling blood are much more likely to be only self-interested. They may not care if tainted blood harms someone. This example illustrates adverse selection.

11. Some life insurance will not pay if the cause of death is suicide within two years of buying the policy, and others will never pay for suicide. Why? No life insurance will pay if the cause of death is a world war. Why?
Moral hazard and adverse selection for suicide. If a person decides he will commit suicide, he would have a tendency to buy the policy to help a friend (adverse selection.) Or if a person has a policy that pays for suicide, he may decide that his best option is to help his family by dying (moral hazard). In the case of world war, the scale of death could be so large that it would financially wipe out the insurance company.

12. Stew D. Much is an enterprising student who is always trying to make a buck. He decides to sell grade insurance to his fellow students. He will pay $500 to any student policyholder who gets an F. Because only 2% of all grades are Fs, Stew computes that he can break even if he charges students $10 per class. To make a profit, he decides to charge $15.
a) Is his arithmetic correct in computing the break-even point? (Ignore other problems.)
b) Will he face a free rider problem? Explain.
no. If you do not pay, you do not get benefits.
c) Will he face a screening problem? Explain.
yes. Students who are likely to get low grades would want to buy; students who are unlikely to get low grades will not buy. He could solve this by charging based on previous GPA.
d) Will he have a problem with moral hazard? Explain.
Yes. A person who is getting a D- may now plead with the instructor to fail him so that he collect. Instead of trying to bring up low grades, students my try to bring them down.

Exploring Quality and Price

13. The judgment of quality by price seems to be important in many markets for services. For example, suppose that there is a surplus of doctors or lawyers. The model of supply and demand suggests that this surplus should reduce price. What problems would a doctor or lawyer face who cuts his prices in order to attract more customers?
If people interpret low prices as an indication of low quality, lowering prices might drive away customers rather than attract them.

Exploring Free Riders

14. JavaScript question

15. Karl Marx defined classes in terms of property relations because then all members of the class would have common interests. He assumed that because all members of the class had common interests, and because they would be aware of these common interests, he could talk about how classes would behave. In their Communist Manifesto Marx and Engels also assumed self-interest: "The bourgeoisie...has left remaining no other nexus between man and man than naked self-interests, than callous 'cash payment'."
a) Suppose that it is in the interests of capitalists as a class to restrict investment to raise the rate of return on capital. Will it be in the individual capitalist's interest to do so?
No. The capitalist is interested only in his bottom line, not the aggregated bottom line.
b) Suppose that it is in the class interests of the proletariat to work together to seize political power. Will it be in the interests of the individual worker to do so?
No. It would be better for the individual worker to free ride. Let others face the risk of death on the battlefield. The benefits will be enjoyed by all.
c) Marx assumed that self-interest translated into class interests because all members of the class had common interests. Can you see a free rider problem that he and Engels did not see? (Comment: This question is adapted from Mancur Olson's Logic of Collective Action (Harvard Univ. Press, 1965, p. 102-110.)
You should be able to. It is another example of the prisoner's dilemma.

16. A Chicago public television station that gets part of its funds through subscription drives, claims that only 10% of those who watch the station contribute. What is more puzzling to an economist, why 90% do not contribute, or why 10% do? Explain.
Most viewers free ride. One of the ways to reduce free riding is to give gifts (CDs are very popular) to those who donate money. People seem to be more likely to pay the exorbitant price for a special CD than to just donate. There are interesting issues here that I do not understand.

17. Bob Saylor notices that ships often wreck on a rocky reef off the coast where he lives. Reasoning that shippers would like to reduce the risk of shipwreck, he tells them that he will build a lighthouse if they will pay him.
a) Will he face a free-rider problem? Explain.
Yes. Once the lighthouse is built, all benefits whether or not they paid. Historically, a way around this was to get the insurers to pay since there were only a few of them.
b) Will he face a problem of adverse selection? Explain.
No. Adverse selection is not an issue with a public goods.
c) Will he have a problem with moral hazard? Explain.
No. He will not suffer if people become more reckless as a result of the lighthouse.

18. When music was distributed on vinyl records, there was no problem with music piracy. Now that digital distribution has arrived, there is a problem with music piracy. An economist would say that the reason music piracy is now a problem for music producers is that technology has made music less like a private good and more like a public good. Explain the economists' position in plain language that ordinary people can understand.

Once it is digital, it is virtually costless to produce another copy--it essentially becomes non-rival. And music companies have found that it is hard to exclude people once things are circulating.

19. a) Those who produce computer software find that software piracy is widespread. There are a lot of people who use software they never paid for. From an economic point of view this is not surprising because software is very much like a public good. List the two characteristics of a public good and explain to what extent computer software has the characteristics.

Non-rivial--the digital world is just information and information is usually non-rival. Once it is available, others can share it. And the structure of the internet makes distribution pretty much non-excludable.

b) Some very clever computer programmers have tried to make money by way of shareware. Shareware authors wrote clever programs, distributed them on electronic bulletin boards (back in the days before the world-wide web, which is when shareware was at its peak) and other low cost distribution methods. People could then try the software, and if they found it useful, they were asked to pay for the software. What obvious problem should an economist see with trying to make money with shareware?

Freeriders--people who use the programs and do not pay. Shareware authors often put in some kind of crippling feature to give people a reason to pay--when they pay, they can remove the crippling feature.

20. Search the internet to find what a "club good" is. What are examples? How is it different from a public good? Also, search for "free rider" or "free rider effect." Can you find any interesting examples of free riders? (Do not forget those urls!)

A club good is nonrival but excludable. It also has other names. Other parts of the answer will vary.

21. Many textbooks have tables that classify several types of goods on a table similar to that below. See if you can figure out where each of the following should be placed:
a) A hamburger is an example of a private good. Where does it belong?
b) The services of a lighthouse are an example of a pure public good. Where does a pure public good belong belong?
c) A club good is a good that is available to many but for which it is easy to charge. An example is cable TV. Where does a club good belong on the table?
d) Fish in the middle of the ocean are commonly owned, or owned by no one, which means the same thing. Where do fish in the middle of the ocean belong on the table?

Exploring Path Dependence

21. The standard typewriter keyboard (the QWERTY arrangement of keys) was developed in the 19th century to prevent typists from typing too fast. When typists typed too fast, the keys would jam. With modern electronic typing, this problem has been eliminated. Why doesn't the world switch to a more efficient keyboard? (Hint: Look at the costs and benefits for a single individual making the switch. Recall that a typist may not always type on the same machine. Is there a free-rider type of problem here?)
If I learn an alternative keyboard, I will be lost when I encounter a QWERTY keyboard, which I do almost every day. Hence, it is not in my interests to learn an alternative. Many people react the same way. Unless a critical mass of the alternative get established, it will die. But it will never reach the critical mass.

22. The success of eBay led to the establishment of many auction sites on the web, Most of them copied the structure and policies of eBay, yet none of the imitators is nearly as successful as eBay. Yahoo, for example, is one of the biggest of the Web companies, yet its auction site, which does not charge sellers commissions, is small compared to eBays.

If you were a seller, would it not be better to list at Yahoo, which does not charge anything for listing or selling, than to list at eBay, which charges a $.25 listing fee and a commission of up to 5% on sales? The services that Yahoo offers both buyers and sellers are almost identical to those on eBay, yet the Yahoo auctions are empty compared to those on eBay.

Visit both auction sites, and Look at the number of auctions in each and the number of bids that items get. Come up with a hypothesis about why eBay is bigger than Yahoo (or any of the other auction sites.) (Hint: The last section argued that in some industries, bigness begets bigness. Once you get big, you stay big. Why would this happen in an auction site?)

If you are a seller, you want to go where they buyers are, which is to the biggest site. You will get more bids, so you are likely to sell your product for a higher price. If you are a buyer, you want to go where the sellers are because you will get a bigger selection. If you have time, you can visit the smaller sites, but the variety is not there. In the auction business, once you are big, you tend to stay big.

Extra Stuff . . Chapter 11 . . Chapter12