AP_Krugman_Textbook

Module 80

Check Your Understanding

1. a.As you can see from the accompanying diagram the four
   bundles are associated with three indifference curves: B
   on the 10-util indifference curve, Aand Con the 6-util
   indifference curve, and Don the 4-util indifference
   curve.

b.From comparing the quantities of chocolate kisses and

licorice drops, you can predict that Samantha will prefer

Bto Abecause Bgives her one more chocolate kiss and

the same number of licorice drops as A.Next, you can

predict that she will prefer Cto Dbecause Cgives her

one more chocolate kiss and the same number of licorice

drops as D.You can also predict that she prefers Bto D

because Bgives her two more licorice drops and the same

number of chocolate kisses as D.But without data about

utils, you cannot predict how Samantha would rank A

versus Cor Dbecause Cand Dhave more chocolate kiss-

es but fewer licorice drops than A.Nor can you rank B

versus C,for the same reason.

2. Bundles Aand Beach generate 200 utils since they both
   lie on the 200-util indifference curve. Likewise, bundles A
   and Ceach generate 100 utils since they both lie on the
   100-util indifference curve. But this implies that Agener-
   ates 100 utils and also that Agenerates 200 utils. This is
   a contradiction and so cannot be true. Therefore, indif-
   ference curves cannot cross.


3. a.The marginal rate of substitution of books for games,
   MUB/MUG, is 2 for Lucinda and 5 for Kyle. This implies
   that Lucinda is willing to trade 1 more book for 2 fewer
   games and Kyle is willing to trade 1 more book for 5
   fewer games. So starting from a bundle of 3 books and 6
   games, Lucinda would be equally content with a bundle
   of 4 books and 4 games and Kyle would be equally con-
   tent with a bundle of 4 books and 1 game. Lucinda finds
   it more difficult to trade games for books: she is willing
   to give up only 2 games for a book but Kyle is willing to
   give up 5 games for a book. If books are measured on the
   horizontal axis and games on the vertical axis, Kyle’s
   indifference curve will be steeper than Lucinda’s at the
   current consumption bundle.
   b.Lucinda’s current consumption bundle is optimal if
   PB/PG,the relative price of books in terms of games, is 2.
   Kyle’s current consumption bundle is not optimal at this
   relative price; his bundle would be optimal only if the rel-
   ative price of books in terms of games were 5. Since, for

023451

7 6 5 4 3 2 1

Quantity

of licorice

drops

Quantity of chocolate kisses

I 1

I 2

AB

C

D

I 3

6 utils

10 utils

4 utils

bad drivers. Good (that is, safe) drivers will find this

insurance premium too expensive and so will remain

uninsured. This is inefficient. However, safe drivers are

also those drivers who have had fewer moving violations

for several years. Lowering premiums for only those driv-

ers allows the insurance company to screen its customers

and sell insurance to safe drivers, too. This means that at

least some of the good drivers now are also insured, which

decreases the inefficiency that arises from adverse selec-

tion. In a way, having no moving violations for several

years is a way of building a reputation as a safe driver.

2. The moral hazard problem in home construction arises
   from private information about what the contractor does:
   whether she takes care to reduce the cost of construction
   or allows costs to increase. The homeowner cannot, or can
   only imperfectly, observe the cost-reduction efforts of the
   contractor. If the contractor were fully reimbursed for all
   costs incurred during construction, she would have no
   incentive to reduce costs. Making the contractor responsi-
   ble for any additional costs above the original estimate
   means that she now has an incentive to keep costs low.
   However, this imposes risk on the contractor. For
   instance, if the weather is bad, home construction will
   take longer, and will be more costly, than if the weather
   had been good. Since the contractor pays for any addition-
   al costs (such as weather-induced delays) above the origi-
   nal estimate, she now faces risk that she cannot control.


3. a.True. Drivers with higher deductibles have more incentive
   to take care in their driving in order to avoid paying the
   deductible. This is a moral hazard phenomenon.
   b.True. Suppose you know that you are a safe driver. You
   have a choice of a policy with a high premium but a low
   deductible or one with a lower premium but a higher
   deductible. In this case, you would be more inclined to
   choose the cheap policy with the high deductible because
   you know that you will be unlikely to have to pay the
   deductible. When there is adverse selection, insurance
   companies use screening devices such as this to infer pri-
   vate information about how skillful people are as drivers.

Tackle the Test:

Multiple-Choice Questions

1. d


2. a


3. b


4. a


5. b

Tackle the Test:

Free-Response Questions

2. This is an example of moral hazard. The government
   bears the cost of any lack of care in the individual/corpo-
   rate decisions. Distorted incentives lead the
   individual/corporation to make riskier decisions because,
   if a decision is bad, the cost falls on others. The individu-
   als/corporations must be given a personal stake in the
   result of their decisions. This could be achieved by mak-
   ing the individuals/corporations repay at least some por-
   tion of the bailout cost.

S-48 SOLUTIONS TO AP REVIEW QUESTIONS