Public Economics

Practicum 3

Discussion Questions Rosen:

8th edition 9th & 10th editions

Chapter 9 5, 6, 7 6, 7, 8
Chapter 10 4, 5 5, 6
Chapter 11 8 8

Additional Exercises:

3.1 Suppose a group of individuals di¤ers in ability a. Ability is private information:

individuals know their own ability, but companies that might employ these
individuals only know that ability is uniformly distributed between 0 and 1.
When self-employed, an individual with ability ai earns 5000 ai . When employed
by a company, the individual creates revenue equal to 5000 ai + 1000. Assume
that companies compete for employees.

(a) When all potential employees would be working for a company, what is the
maximum wage the company would be willing to pay?
(b) If all companies o¤er the wage derived under (a), would all employees
choose to work for a company? If not, which employees would choose to
be self-employed?
(c) In equilibrium, what wage is o¤ered by companies, and which individuals
work for a company?
(d) Is this outcome e¢ cient? Is there a way to improve upon this outcome (in
terms of e¢ ciency)?

3.2 Consider the market for second-hand cars. Suppose that second-hand cars are
either good or bad, and that the fraction of bad cars is 21 . A bad car will surely
break down within 6 months, a good car never breaks down within 6 months.
Sellers know the quality of their cars. A seller’s valuation of a good car is 3000
euro; sellers’valuation of a bad car is 1000 euro. Buyers do not know the quality
of a given car, but do know that cars can be either good or bad (and, hence,
that a seller’s valuation is either 1000 or 3000 euro). Suppose …rst that buyers’
valuation of a bad car is 3000 euro (despite breaking down) and of a good car
5000 euro.

(a) Which cars will be sold, and at which price?

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 Now suppose that buyers’valuation of a bad car is 1600 euro and of a good car
4000 euro.

(b) Is it e¢ cient for both car types to be traded?

(c) Which cars will be sold, and at which price?

Now suppose that there is a third party: the inspectors. By inspecting a car,
which costs 336 euro, they can (credibly) determine whether the quality is good
or bad.

(d) If buyers always have the car inspected before they buy it, how does this
a¤ect your answer to (c)? Does this make the market fully e¢ cient?
(e) It is actually not necessary to have all cars inspected. Show that if sellers
have to bear the cost of inspecting, sellers of bad cars will honestly declare
that their car is bad, such that only good cars are inspected.
(f) It is possible to improve e¢ ciency (i.e. decrease inspection cost) even
further by randomly inspecting only a fraction of the cars o¤ered by sellers
who claim that their car is good. What is the minimum fraction of cars
that have to be inspected when the seller claims that the car is good to
make sure that sellers of bad cars optimally declare that their car is bad?
(g) How would you react to a non-economist arguing: "It is better to buy a
car from marktplaats or e-bay than from an o¢ cial dealer, as thereby you
do not have to pay for the pro…ts of the dealer. The bene…ts are obvious
if you compare the prices."

3.3 Consider a small village somewhere in East-Asia, where the only source of in-
come is bamboo, which can be sold after it has been cut. The utility of a
bamboo-cutter is given by p
U =8 Y
where Y is income. Bamboo-cutting is dangerous, due to the presence of poiso-
nous snakes. However, bamboo-cutters can take precautions, which reduce the
probability of being bitten. Without precautions, this probability is 12 . With
precautions, the probability of being bitten is lowered to 41 . Unfortunately, the
precautions are unpleasant: it reduces utility by 1. If a bamboo-cutter does not
get bitten, his income is YG , if he does get bitten by a snake, his income is YB .

(a) What is the expected utility of a bamboo-cutter who takes precautions?

And what is it if he does not take precautions?

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Now suppose that YG = 4 and YB = 0.

(b) Show that a bamboo-cutter optimally takes precautions.

Now suppose that bamboo-cutters can insure themselves against the loss of
income after a snake-bite. An insured bamboo-cutter pays a premium p. If
he gets bitten, the bamboo-cutter receives a payment of 4 from the insurance
company.

(c) Show that an insured bamboo-cutter does not take precautions.

The insurance market is perfectly competitive, such that premiums are actu-
arially fair (i.e. the insurance companies make no pro…ts, in expected terms).
However, insurance companies cannot determine whether bamboo-cutters take
precautions or not.

(d) Calculate the premium. Is it optimal for bamboo-cutters to buy insurance?

(e) Show that if bamboo-cutters would be able to commit to taking precautions,
and the premium would adjust to account for the lower probability of
snake-bites, then bamboo-cutters would be better o¤. Discuss.

Now suppose that there is a second group of bamboo-cutters. These people are
identical to the …rst group, except that they are born with a special ability for
avoiding snakes. This implies that their probability of being bitten is only 0:1
(regardless of precautions). The two groups are equally large.

(f) If insurance companies would be able to distinguish between the two groups,
would the second group insure themselves against the income loss due to
snake-bites?
(g) If insurance companies would not be able to distinguish between the two
groups, would the second group insure themselves against the income loss
due to snake-bites?

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Answers to exercises week 3

Rosen 9.5 / 9.6

a)  = 100 − 25, with  = 50 gives  = 2 visits per year. Total cost is 100.
b) With 50 percent coinsurance, the individual pays $25 per visit and the quantity
demanded is 3 visits per year. The individual’s out-of-pocket costs are $75 and the
insurance company pays $75 ($25 per visit, 3 visits per year).
c) The introduction of insurance caused the quantity demanded to increase from
2 to 3 because the individual’s effective price fell from $50 to $25, but the marginal
cost is still $50 per visit. The individual consumes medical services past the point
where the marginal benefit to the individual equals the marginal cost, leading to
inefficiency or deadweight loss. The deadweight loss (triangle) is equal to $12.50.
d) If the marginal external benefit of visiting the doctor is $50, the socially
optimal outcome is  = 4. As the individual still chooses  = 3, there is a suboptimal
outcome now (i.e. the subsidy is below the marginal external benefit). Compared to
the social optimum, this outcome is still $1250 less efficient.

Rosen 9.6 / 9.7

a) There is a 95 percent chance of no illness, in which case income is $30,000,
and a 5 percent chance of illness, in which case income is $10,000 because of the
$20,000 loss. Thus, expected income = 29,000. The utility of having a certain in-
come of $29,000 is 11.66, but the expected utility of this uncertain income is only
095 · (30 000) + 005 · (10 000) = 1164.
b) An actuarially fair premium would be $1,000 since there is a one in twenty
chance that the insurance company will have to cover losses of $20,000. If the indi-
vidual buys insurance for $1,000, then they have certain income of $29,000 and the
utility of $29,000 is 11.66.
c) Setting the expected utility equal to 11.64 and solving for income yields ap-
proximately $28,388, indicating that the individual is indifferent between bearing the
risk and having expected income of $29,000 or purchasing insurance with a certain
income of $28,388. Hence, if the insurance costs $30,000 - $28,388 = $1,612, the
individual is indifferent between having insurance and not having insurance.

Rosen 9.7 / 9.8

In both options, the expected fine is 20. Denoting the value of littering by  and
income by  , the first option gives an expected value of littering equal to 08(  )+
02 (  − 100), whereas the expected value of littering with the second option is
09 (  ) + 01 (  − 200). Assuming diminishing marginal utility of income
(i.e. risk-aversion with respect to income), expected utility is smaller in the second
case than in the first case. Hence, the second option has a stronger deterrent effect,

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leading to a larger reduction in littering. In addition, setting higher fines is cheaper
than employing more police officers.

Rosen 10.4 / 10.5

The budget constraint initially has units of Medigap on the x-axis, and other goods
on the y-axis. Given initial prices of $1 per unit for each good, and $30,000 of income,
the budget constraint has a slope of -1, and the intercepts on both axes are at 30,000
units. It is assumed that the initial utility maximizing bundle consumes 5,000 units
of Medigap, hence the indifference curve is tangent at (5000,25000). All of this is
illustrated in the figure below.

Medigap choice without minimum

standards
Other Goods

30,000

25,000

U0

5,000 30,000 Medigap

efficiency
units

Rosen 10.4(a)

After the “minimum Medigap” mandate, the consumer can either choose 0 units of
Medigap or 8,000 or more units of Medigap. Thus, part of the budget constraint is
eliminated (though the overall shape remains the same as before). After the mandate,
the point (0,30000) is available, as well as all of the points to the southeast of the
point (8000,22000). Clearly, the person’s utility must fall since the preferred choice,
(5000,25000) is no longer available. If the person attains a higher level of utility as
(0,30000) compared with (8000,22000), the person chooses to not purchase Medigap.
In this case, the marginal rate of substitution is no longer equal to the price ratio.

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This is illustrated below.
Medigap choice with minimum
standards; no Medigap is purchased
Other Goods

30,000

25,000

U0
U1
22,000

5,000 8,000 30,000 Medigap

efficiency
units

Rosen 10.4(b)

Rosen 10.5 / 10.6

If individuals are allowed to purchase supplemental private insurance, then the budget
constraint in Figure 10.5 of the textbook is modified by drawing a line starting at
point B that runs to the southeast and is parallel to AC.

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 Individuals can purchase
Other Goods
supplemental private insurance
A
B

C
M
Health
Insurance

Rosen 10.5(b)

If individuals pay for health insurance (rather than perceiving it as being free), and the
insurance was paid for with a lump sum tax, then the budget constraint shifts in by an
amount that depends on the household’s share of the tax burden. If the household’s
tax burden exactly equals the cost of health insurance, the budget constraint is no
longer the line segment AD but rather the segment BCD, where the segment CD
runs along the original budget constraint, except that the minimum amount of health
insurance consumed is M.

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 Other Goods
Government health insurance is financed by
A taxes

B C

D
M
Health
Insurance

Rosen 10.5(b)

Rosen 11.8 / 11.8

a) The problem does not provide information about the utility function, so the
optimal point is where the indifference curve is drawn tangent to the budget line,
which can occur at different values depending on how the curve is drawn. In the dia-
gram below, the optimal point involves saving $8,000 and future consumption consists
of period 2 income ($5,000) plus savings with interest ($8,800). (note that the present
value of consumption is $24,525, rather than the $25,545 specified in the figure

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 $27,000

$13,800 . Optimal
P i

Endowment
$5,000 .Point

$12,000 $20,000 $25,545 Present

Consumption

Rosen 11.8

b) If Social Security takes $3,000 from the individual in the first period and
pays him this amount with interest in the second period, then private savings falls
from $8,000 to $5,000. There would be no change in optimal consumption values.

Exercise 3.1
Drawing the uniform distribution helps!
a) Average revenue equals 12 ([5000 · 0 + 1000] + [5000 · 1 + 1000]) = 3500 (uniform
distribution of ability). Hence, when all employees work for a company, on average
they create 3500 in revenue, so that the company is maximally willing to pay a wage
equal to 3500.
b) Given wage  = 3500, all individuals with ability  such that 5000· ≥ 3500
prefer to be self-employed. Rewriting yields  ≥ 07. Hence, the most productive
employees leave the company: adverse selection.
c) Companies anticipate upon the above: when they would pay a wage equal to 3500,
the average revenue of employees would only be 12 ([5000·0+1000]+[5000·07+1000]) =
2750, implying that companies would make a loss (on average). Hence, companies
pay lower wages, which in turn implies that more (relatively able) individuals choose
to be self-employed.
To find the equilibrium, denote the ability of individuals who are just indifferent
between being self-employed and being employee by ∗ . Hence, ∗ is given by ∗ =
5000 · ∗ , where ∗ is companies’ wage in equilibrium. The wage must be such that
the average productivity of all employees is equal to this wage (zero-profit). This

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gives: ∗ = 12 ([5000 · 0 + 1000] + [5000 · ∗ + 1000]). Substituting for ∗ = 5000 ∗ ∗
gives
1
5000 · ∗ = ([5000 · 0 + 1000] + [5000 · ∗ + 1000])
2
which can be rewritten to
1 1 1000
5000 · ∗ = (1000 + 1000) → ∗ = = 04
2 2 2500
Which implies that equilibrium wage ∗ = 2000. Hence, the least able 40% of all
individuals works for companies and earns a wage of 2000, the rest is self-employed.
d) Efficiency requires that all individuals work for a company (revenue created is
1000 higher). Inefficiency arises because of private information. If information can
be (credibly) shared, outcome may be improved. Two ways to achieve this are:
— Pay-for-performance (or screening): if companies can make individuals’ wages de-
pended on the revenue they create, the adverse selection problem does not arise. See
Personnel Economics for more info.
— Signalling: If individuals can somehow credibly signal their ability (for instance by
doing studies which are more easy to finish with high ability), companies can pay
higher wages to high-ability individuals.
Note: both of these possible solutions (can) have negative effects: pay-for-performance
may not work perfectly (risk, distortions), which reduces efficiency, and when sig-
nalling is costly, there may be too much signalling (from an efficiency perspective).

Exercise 3.2
a) When price  ≥ 3000, all cars will be traded. Then, expected value for buyer
is 4000. Hence, maximum price they are willing to pay is 4000. When the price 
would be lower than 3000, high-quality cars would not be sold, and buyers would
anticipate this. Hence, all cars are sold, for a price between 3000 and 4000.
b) Yes, for both good and bad cars, buyers’ valuation is higher than sellers’
valuation.
c) If both types are offered, then the expected value for a buyer is 2800. Hence,
if all cars would be traded, buyers would be willing to pay maximally 2800. At that
price, sellers of good cars do not offer their car for sale. Hence, only low quality cars
are sold. Buyer anticipate this, which implies that they will never pay more than
1600. Hence, the price lies somewhere between 1000 and 1600.
d) Buyers can determine the quality of the car, at the cost of 336. Hence,
including the inspection cost, their valuation of a bad car is 1264 and of a good car
3664. Now, (before inspection) buyer and seller can agree to a price between 1000
and 1264 if the car turns out to be bad and a price between 3000 and 3664 if the car
turns out to be good. Even though all cars are being traded now, which is efficient,

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the inspection cost are a waste. Hence, the inspection cost are a necessary bad in
order to avoid an even greater inefficiency: the withdrawal of good quality cars from
the market.
e) It is better to have the cars inspected only when the seller claims that the car is
good. Since sellers know the quality of their car, inspecting bad cars is not necessary.
Hence, a better solution is that sellers of good cars have their cars inspected, and that
inspected cars trade for a price between 3336 and 4000. Bad cars are not inspected,
and are traded for a price between 1000 and 1600.
f) As inspection is costly, less inspections is better (i.e. more efficient). However,
if no car is inspected and the price of a good car would be higher than the price of a
bad car, all sellers would claim that their car is good. Here, we look for the minimum
probability of inspection of cars claimed to be good by their sellers, denoted by , at
which sellers of bad cars still do not have an incentive to claim that their car is good.
Suppose the price of a good car is  and the price of a bad car is  . If a seller
claims the car is good, the probability that the car is inspected is . Cars are sold as
good cars if they are inspected and found good, as well as when the seller claims the
car is good but the car is not inspected. Clearly, a seller of a good car will always
claim that the car is good. Consider a seller of a bad car. If he claims the car is bad,
he gets price  . If he claims the car is good, either the car is not inspected (with
probability 1 − ), in which case he gets  , or the car is inspected (which happens
with probability ), yielding price  − 336 (inspection cost). Hence, the seller of a
bad car is honest when

 ≥ (1 − ) +  [ − 336] → (1 − ) ≥ (1 − ) − 336

To find the minimum  for which this inequality holds (so that inspections are min-
imised), we should substitute for the highest possible  and the lowest possible  .
Buyers maximally pay 1600 for a bad car, sellers are willing to sell a good car at
minimally 3000 + 336 (as in expectation, they have to pay 336 in inspection cost).
This gives

(1 − )1600 ≥ (1 − )[3000 + 336] − 336

0 ≥ 1400(1 − ) − 3362
5
which can be solved for  ≥ 6
(using a good calculator/math program).

Thus, in order to maximise efficiency in this market, it should be that  = 1600,

 = 3000 + 336 · 56 = 3280, and the probability of inspection in case the seller claims
the car is good = 56 .
g) Part of the higher price of the dealer is the inspection cost and the warranty.
The information dealers provide about quality is valuable.

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Exercise 3.3 √ √
a) Expected utility with precautions:  =√6  +√2  − 1.
Expected utility without precautions:  = 4 √+ 4 √  .
b) Expected utility with precautions:  = √6 4√ + 2 0 − 1 = 11.
Expected utility without precautions:  = 4 4 + 4 0 = 8. √ √
c) √Expected utility with insurance and precautions:  = 6 4 − +2 4 − −
1 = 8 4 −  − 1. √ √

Expected
√ utility with insurance but without precautions:   = 4 4 − +4 4−=
8 4 − .
d) The premium  should be equal to the expected payout, given that bamboo-
cutters do not take precautions:  = 12 0 + 12 4 = 2. Hence, expected utility with

√
insurance (and without precautions) is  = 8 2 = 113. Expected utility with-
out insurance is  = 11 (note that under (b), we derived that without insurance,
they would take precautions). Hence, they prefer to buy insurance.
e) If bamboo-cutters could (credibly) commit √ to taking precautions, the premium
3 1 
would be  = 4 0+ 4 4 = 1. Hence,  = 8 3−1 = 129. Thus, although moral haz-
ard makes bamboo-cutters better off given that they have insurance, the fact that the
insurance companies anticipate this moral hazard and adjust their premium implies
that bamboo-cutters are actually worse off due to their own moral hazard behaviour.
They would prefer to be able to commit themselves to always taking precautions.
f) Premium for the second group would √ be 2 = √ 09 · 0 + 01 · 4 = 04. Expected
utility without insurance is  √ = 09 · 8 4 + 01
√ · 8 0 = 144. Expected utility with
insurance equals  = 09 · 8 4 − 04 + 01 · 8 4 − 04 = 152.
g) There
£ can be ¤ only one premium. If everyone is insured, expected payout is
given by 12 12 0 + 12 4 + 12 [09 · 0 + 01 · 4] = 12 (note: first part is expected payout to
a member of group 1, second part expected payout to member of group √ 2). Expected
utility
√ of a member of group two with this insurance is  = 09 · 8 4 − 12 + 01 ·
8 4 − 12 = 134. This is smaller than their utility without insurance. Hence, group
two will not insure themselves, implying that only group 1 insures, at a premium
 = 2.
Note that this is not the efficient outcome, as groups 2 does benefit from insurance.
This is an example of how asymmetric (or private) information can lead to adverse
selection, and, thereby, to reduced efficiency.

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