Econ 2

1
Econ 2

• Final 30 to 35 on Ch 5, Ch12-16
• 65 to 70 on Ch 17 Ch 20
• on Friday,12/12, from 1130 - 230pm.
• The tentative room for this final is
• Warren Lecture Hall room 2001
• Midterm exams can be picked up during my office
  hours
• Practice problems for Ch 18, 19, and 20 will be
  posted before Thursdays lecture.
• Please bring a pencil on Thursday, we will do TA
  evaluations!

2
Review Economic Inequality

• Measurement
• Sources
• Income Redistribution

3
Income Lorenz Curve
Income Lorenz Curve
Line of perfect equality
Cumulative of income
The greater this area the more unequal the
distribution
Cumulative of households
4
Calculating the Gini Coefficient
Although the Lorenz Curve is good visual
indicator of distribution equality, the Gini
Coefficient provides a clearer quantatitive
value. Area A / Area B Gini coefficient Values
should lie between 0 (total equality) to 1 (total
inequality).
B
A
Line of perfect equality
Cumulative of income
The greater this area the more unequal the
distribution, and the higher the Gini coefficient
Cumulative of households
5
The big tradeoff

• The redistribution of income creates a tradeoff
  between equity and efficiency.
• Because redistribution uses scarce resources and
  weakens incentives.
• Administrative cost is only a small part of the
  total cost of redistribution, a bigger cost
  arises from the inefficiency (DWL) of taxes and
  benefits

6
Uncertainty and Risk
7
Peoples attitude towards Risk

• Risk averse
• Risk neutral
• Risk loving

8
The Utility of Wealth Curve

• Risk averse each additional unit of wealth
  increases total utility by a smaller amount.
• Risk neutral each additional unit of wealth
  increases total utility by an equal amount.
• Risk loving each additional unit of wealth
  increases total utility by a greater amount.

9
Being Risk Averse

• U (the expected value of a lottery) gt EU of the
  lottery
• So a risk averse person prefers getting a check
  with the average value of the gamble for sure to
  taking the gamble

10
Being Risk Averse

• It takes a smaller amount of wealth in a no-risk
  situation to yield the same expected utility as
  in the case of a gamble.
• In other words, to induce a person to accept a
  gamble that yields the same expected utility, we
  must increase the expected value of the gamble.
• The amount of the expected value we have
  increased to just offset the risk that person
  bears (so that the person still has the same
  expected utility) is called the cost of risk.

11
Private Information
Behavior changes post agreement

• Moral Hazard
• After the agreement has been made,
• because the cost of monitoring is high,
• one of the parties has an incentive to
• act in a manner that brings additional
• benefit to himself at the expense of the
• other party.
• Drive carefully/not Work hard / not

12
Who Wants to Be a Millionaire

• The show was insured in case a contestant
  answered all the questions correctly
• Moral hazard on the part of the producer ease
  the questions asked in order to guarantee that
  some one will win and thereby boost the shows
  excitement and rating
• So the insurance company wanted greater control
  over the difficulty of the questions being asked
  of the contestants

13
Private Information
People come in different types. It is difficult
to tell their true types.

• Adverse Selection
• One party knows his true type before entering an
  agreement,
• but the other party does not know,
• The party that has the private information has a
  tendency to
• enter into the agreement in which she can
• use her private information to her advantage
• and to the disadvantage of the less informed
  party.
• High risk / Low risk Healthy / Unhealthy

14
Market for Used Cars

• Suppose only have lemons (1000) and good cars
  (5000)
• Is the car a lemon? private information
  available only to the car owner
• Buyers cant tell until after they have bought
  the car
• How much are buyers willing to pay?
• Less than 5000, because positive probability of
  getting a lemon
• If so, owners of good cars are not willing to
  sell, so they hang onto their cars, only the
  owners of lemon are willing to sell

15
Market for Used Cars

• Suppose only have lemons (1000) and good cars
  (5000)
• If only the owners of lemons are willing to sell,
• All the available used cars are lemons
• So buyers will pay 1000 at the maximum
• And the market for used cars is a market for
  lemons
• In other words, only lemons actually being traded
• - Adverse selection exists

16
Market for Used Cars

• So the market for used cars is not working well
• Suppose dealers can tell a lemon apart from a
  good car
• fix introducing dealer warranties into the
  market
• The dealer signals which cars are good ones by
  offering warranties on good cars
• Why do buyers believe the signal?
• The cost of sending a false signal is high risk
  of paying high repair cost, risk of injuring
  reputation of the business
• So warranties break the lemon problem (the
  adverse selection problem)