C61D0001d01 - Suggested Answers for Problem Set#2 Econ 441...

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Suggested Answers for Problem Set #2 Econ 441 – Fall 2001 Chapter 10 #3 The rationale is that by requiring everyone to sign up right away, the government avoids adverse selection problems. If individuals can sign up at any time, they might only choose to sign up when they know they will be needing expensive drugs (making the program very expensive). Chapter 10 #4 2. In Eden, Eve does the fishing and Adam makes the clothes – they then barter clothes for fish. Adam dumps dye into the lake, which lowers Eve’s fishing yield. There is no need for a higher power to intervene to address Adam’s negative externality on Eve. UNCERTAIN: If the property rights to the lake are clearly assigned either to Adam or to Eve, then there is no need for intervention. We know they have costless bargaining, since they already engage in trade. If the property rights are no assigned (or if you think the higher power would be needed to assign the rights), then there is need for
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intervention. Note that the fact that dumping raises the price Adam faces for fish does not mean that he internalizes the externality. He internalizes only the effect of dumping on his consumption of fish, not the effect on Eve’s consumption of fish. b) There is no reason for state or federal subsidization of education, since people who live in areas with low educational spending prefer low taxes to high education spending. FALSE We might want to subsidize education since education creates a positive externality. 3. Your expected utility without insurance is EU =.9log (2*50) +.1log(2*20) = 1.960. The actuarially fair price for insurance is the probability of loss times the amount of the loss, so .1*30,000 = $3,000. Your expected utility if you buy the insurance is EU = log(2*47) = 1.973. Let the amount you pay for full insurance be x. Then your expected utility from insurance is log(2*(50-x)). So the most you will pay for insurance is the solution to log(2*(50-x))= 1.960, x =$4,399.45 4. 1) Each superhero's utility exhibits diminishing marginal returns (you can see this by simply plotting the level of utility against consumption, or by finding that the second derivative is negative). This is equivalent to saying that the individual is risk averse. Since
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