Question & Answer

What actions can either the buyers or sellers take in each of the examples in Table 5.1 to help overcome some of the potential problems caused by the unobservable characteristics?

1. Why are insurance companies unwilling to provide insurance against losses arising from war or ‘civil insurrection’?

2. Name some other events where it would be impossible to obtain insurance.

3. Explain why an insurance company could not pool the risk of flooding in a particular part of a country. Does your answer imply insurance against flooding is unobtainable?

If people are generally risk averse, why do so many people around the world take part in national lotteries?

Do you think that this provides a moral argument for redistributing income from the rich to the poor? Does it prove that income should be so redistributed?

Which gamble would you be more likely to accept, a 60:40 chance of gaining or losing £10 000, or a 50:50 chance of gaining or losing £1? Explain why.

What is the expected value of the lottery ticket gamble if the chances of purchasing a winning ticket are 1 per cent? How much of the certain pay-off is a risk-loving person willing to sacrifice if they decide to purchase the lottery ticket? If they were indifferent between purchasing and not purchasing the ticket what is their certainty equivalent and risk premium of the gamble?

What is the expected value of the above lottery ticket gamble if the chances of purchasing a winning ticket with a prize of £50 are 30 per cent? How much of the expected value of the gamble is a risk-averse person willing to sacrifice if they decide against purchasing the ticket? If they were indifferent between purchasing and not purchasing the ticket, what is their certainty equivalent and risk premium of the gamble?

Explain the difference between ‘risk’ and ‘uncertainty’.

Threshold Concept 9) 1. What risks are involved in buying the latest version of the iPhone? Compare these with the risks of buying a house.

(Threshold Concept 9) 2. Give some examples of ways in which it is possible to buy better information. Your answer should suggest that there is profitable business to be made in supplying information.

(Threshold Concept 9) 3. Is there a role for government intervention in the provision of information?

Drawing an indifference curve diagram that illustrates Giffen behaviour can be difficult. Given that the substitution effect of the price change must be relatively small, how do you draw the indifference curves: i.e. how bowed in towards the origin should they be?

         Illustrate on two separate indifference diagrams the income and substitution effects of the following:

(a)    A decrease in the price of good X (and no change in the price of good Y).

(b)    An increase in the price of good Y (and no change in the price of good X)

As quantity demanded increases from Q₁ to Q₂ in Figure 4.15 the expenditure on all other goods decreases. (Point b is lower than point a.) This means, therefore, that the person’s total expenditure on X has correspondingly increased. What, then, can we say about the person’s price elasticity of demand for X between points a and b? What can we say about the price elasticity of demand between points b and c and points c and d?

Illustrate on an indifference diagram the effects of the following:

(a)    A rise in the price of good X (assuming no change in the price of Y).

(b)    A fall in the price of good Y (assuming no change in the price of X).

1. The income–consumption curve in Figure 4.12 is drawn as positively sloped at low levels of income. Why?

2. Show the effect of a rise in income on the demand for X and Y where this time Y is the inferior good and X is the normal good. Is the income–consumption curve positively or negatively sloped?

1. Assume that the budget remains at £30 and the price of X stays at £2, but that Y rises in price to £3. Draw the new budget line.

2. What will happen to the budget line if the consumer’s income doubles and the price of both X and Y double?

Draw another two indifference curves on Figure 4.5, one outward from and one inward from the original curve. Read off various combinations of pears and oranges along these two new curves and enter them on a table like Table 4.2.

Although indifference curves will normally be bowed in toward the origin, on odd occasions they might not be. Which of the diagrams correspond to which of the following? Explain the shape of each curve.

(a)  X and Y are left shoes and right shoes.

(b)  X and Y are two brands of the same product, and the consumer cannot tell them apart.

(c)  X is a good but Y is a ‘bad’ – like household refuse.

(Looking at the Maths) What is the present value (utility) of a good which yields £50 of utility at the end of year 1, £60 at the end of year 2, £100 at the end of year 3 and £50 at the end of year 4, assuming a discount factor of 0.9? Would it be worth the consumer paying £200 for it today?

1. (a) What discount factor is used to weight benefits that occur in three months’ time for a person with a per-monthly discount factor of 0.9? (b) What does this make the present value of £20 of benefits received in three months’ time?

2. Assume that the good costs £10, which has to be paid today. How long would the maximum delay in (whole) months before receiving the £20 of benefits have to be before a person with a monthly discount of 0.9 would no longer purchase the good.

What is the minimum amount by which the pay-off of £500 would have to increase in order for you personally to agree to wait for another 24 hours before receiving it?

How would marginal utility and market demand be affected by a rise in the price of a complementary good?

Why do we get less consumer surplus from goods where our demand is relatively elastic?

If a good were free, why would total consumer surplus equal total utility? What would be the level of marginal utility?

(Threshold Concept 8) 1. Assume that a firm is selling 1000 units of a product at £20 each and that each unit on average costs £15 to produce. Assume also that to produce additional units will cost the firm £19 each and that the price will remain at £20. To produce additional products will therefore reduce the average profit per unit. Should the firm expand production? Explain?

(Threshold Concept 8) 2. Assume that a ferry has capacity for 500 passengers. Its operator predicts that it will typically have only 200 passengers on each of its mid-week sailings over the winter. Assume also that each sailing costs the company £10,000. This means that mid-week winter sailings cost the company an average of £10 000/200 = £50 per passenger. Currently tickets cost £60. Should the company consider selling stand-by tickets during the winter for (a) less than £60; (b) less than £50? (Clue: think about the marginal cost of taking additional passengers.)

If Ollie were to consume more and more crisps, would his total utility ever (a) fall to zero; (b) become negative? Explain.