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Unformatted text preview: Intermediate Microeconomics, Winter 2008 Problem Set No 21 due: Wednesday, April 9; Thursday, April 10 Reading: "Moral Hazard," Chapter 19, pp 662 - 679. Q1. Taxes . What is the problem of taxation? Suppose a government wants to provide defense to its citizens and needs to raise a &xed amount of money by taxing labor. Consider the World of Truth: If the government could perfectly observe everything (preferences, amount of labor provided), argue that the government might be able to raise taxes without inducing distortions. Why does this change if preferences are not observable? Can you compare the problem of &nding the right tax to the problem of a monopolist &nding the right price? Q2. Adverse Selection . Reconsider the used car example from the lecture. The probability of the used car having low quality is L . a) Can you &nd the optimal price o/er by the buyer as a function of ¡ L ? Recall that the buyer has to consider only two prices, c H and c L . So, you will have to calculate for which value of L the buyer wants to make an o/er that the car seller always accepts ( p = c H ) and for which value of L the buyer wants to make an o/er such that the seller accepts only of he has a low valuation for the car ( p = c L ). b) As you will see, sometimes the buyer will only buy the low quality car. This might be because the buyer wants to maximize his payo/. But for some values of L , even if the buyer would be nice and o/er a fair price whenever possible, trading the high quality car is not possible unless the buyer is willing to incur losses. For which values of L would even such a nice buyer not buy the high quality car?...
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This note was uploaded on 12/10/2011 for the course ECON 401 taught by Professor Burbidge,john during the Winter '08 term at Waterloo.
- Winter '08