1. If All Cars Were Offered for Sale, the Expected Value to a Seller Would Be 500 X 50%

Answers

1. If all cars were offered for sale, the expected value to a seller would be 500 x 50% + 1200 x 25% + 2000 x 25% = 1050. The value to a buyer, and hence the price (recall, there are more buyers than sellers, so the price is equal to the buyers’ willingness to pay) would then be 1050 + 20% 1050 = 1260. At this price, however, good quality cars would not be offered for sale. Thus, suppose that only lemons and intermediate quality cars are offered. The new average value to buyers would then be 500 x 2/3 + 1200 x 1/3 = 733 1/3. The expected value to sellers would be 20% larger, i.e. 880. At this price, however, intermediate quality cars will not be offered for sale. Eventually, only lemons are sold at a price of 600.

2. The problem is that Leicester residents have an incentive to understate their true valuation of the public good in order to pay less. This is an example of free riding.

3. In case A only a limited number of agents are involved and the issue at stake is large, since the stink may negatively affect the value of properties. Thus, transaction costs are likely to be relatively low and a Coase-style bargaining solution seems likely. In case B, transaction costs are enormous, since each driver would have to bargaining with all other drivers, before leaving home! (When he is already on the motorway, he is already contributing to create a problem of congestion.) In this case, a Coase-type solution is almost impossible to emerge. Case C is intermediate between cases A and B, although a bargaining solution seems unlikely.

4. Since the duration of monopoly is shorter, the expected profits accruing to innovators are lower. Hence, the incentive to innovate will be lower, reducing the investment in R&D and the rate of innovation. In the short run, consumers will benefit since the innovations discovered in the past are less protected. The price of innovative goods will fall to the competitive level earlier, and this will benefit consumers. In the long run, however, the picture is less clear. The monopoly over innovative good is shorter, so prices fall to competitive levels earlier. However, there will be less innovation, which harms consumers. In general, either effect may prevail.

5. If a 10% increase in price would decrease demand by only 5%, the firm must be operating at a point where marginal revenue is negative, and hence profits cannot possibly be maximised. In particular, the output is above the profit maximising level. To avoid being fired, Paul might argue that although this strategy does not maximise the firm profit in the short run, it is optimal in the long run because it reduces future costs (e.g. through a learning by doing effect) or increases future demand (e.g. by driving competitors out of the market).

6. In the health insurance market, the “lemons” are the people who already suffer, or are more likely to suffer, from serious, chronic diseases. Although insurance company can screen customers (e.g. by medical tests), they are typically less well informed than the patients themselves. Hence we have a problem of asymmetric information. At any given price for insurance, the more healthy people would not demand health insurance, and only the less healthy ones will. This creates and adverse selection problem, that negatively affects the working of the market. If health insurance was compulsory, there would be no adverse selection. There would be still a lot of uncertainty (insurance companies still will not know which patients will be sick, and how serious their diseases will be), but using statistical information, when the number of consumers buying insurance is large, they would be able to estimate the risk quite precisely.

7. The statement that "an increase in the demand for notebooks raises the quantity of notebooks demanded, but not the quantity supplied," in general, is false. As Figure 1 shows, the increase in demand for notebooks results in an increased quantity supplied. The only way the statement would be true is if the supply curve was a vertical line, as shown in Figure 2.

Figure 1

Figure 2

8. a. If people decide to have more children (a change in tastes), they will want larger vehicles for hauling their kids around, so the demand for minivans will increase. Supply won't be affected. The result is a rise in both price and quantity, as Figure 3 shows.

Figure 3

b. If an increase in the demand for steel in China raises steel prices, the cost of producing a minivan rises (a rise in input prices), so the supply of minivans decreases. Demand won't be affected. The result is a rise in the price of minivans and a decline in the quantity, as Figure 4 shows.

Figure 4

c. The development of new automated machinery for the production of minivans is an improvement in technology. The reduction in firms' costs results in an increase in supply. Demand isn't affected. The result is a decline in the price of minivans and an increase in the quantity, as Figure 5 shows.

Figure 5

d. The rise in the price of sport utility vehicles affects minivan demand because sport utility vehicles are substitutes for minivans (that is, there is a rise in the price of a related good). The result is an increase in demand for minivans. Supply is not affected. In equilibrium, the price and quantity of minivans both rise, as Figure 3 above shows.

e. The reduction in peoples' wealth caused by a stock-market crash reduces their income, leading to a reduction in the demand for minivans, since minivans are likely a normal good. Supply isn’t affected. As a result, both price and quantity decline, as Figure 6 shows.

Figure 6

9. A temporarily high birth rate in the year 2010 leads to opposite effects on the price of babysitting services in the years 2015 and 2025. In the year 2015, there are more 5-year olds who need sitters, so the demand for babysitting services rises, as shown in Figure 7. The result is a higher price for babysitting services in 2015. However, in the year 2025, the increased number of 15-year olds shifts the supply of babysitting services to the right, as shown in Figure 8. The result is a decline in the price of babysitting services.

Figure 7 Figure 8

10. a. As Figure 9 shows, the supply curve is vertical. The constant quantity supplied makes sense because the stadium has a fixed number of seats no matter what the price.

Figure 9

b. Quantity supplied equals quantity demanded at a price of £20. The equilibrium quantity is 16,000 tickets.

c.

The new equilibrium price will be £30, which equates quantity demanded to quantity supplied. The equilibrium quantity is again 16,000 tickets.