Reference no: EM13163036

1. In section IV of Akerlof (1970), the author discusses several examples of ways that the seller counteracts the effects of quality uncertainty. Can you think of other ways to "guarantee" quality or ways the seller sends signals to prospective buyers that their product or service is "worth it?" With respect to the used car market, can you think of ways that potential buyers can reduce the probability of buying a "lemon?" What other types of markets have been created due to the "lemons" problem?

2. Akerlof (1970) devised an example that showed that cases may arise where information asymmetry causes the market for used cars to perform poorly or even to disappear entirely. Suppose instead that we are analyzing markets involving health insurance. The distribution of these expenditures is shown below, where the horizontal axis measures the expected health expenditure levels of a population n potentially insured people. Assume that they have the same demographic characteristics and that their expected health expenditures levels for the insured period range from a low of $0 up to an expenditure level of $M (in $1/4 increments). The vertical axis represents the probability with a uniform distribution (so that the probability of any level of spending is 1/n). The insurer must at least break even, which means that the premium (or price) received from each insured must cover the insured population's average expenditure and other expenses (including marketing and overhead). In this case, asymmetric information will likely occur because the potential insureds know more about their expected health expenditures in the coming period than does the insurance company. To illustrate, assume a potential insured knows his or her future expenditure exactly but that the insurance company knows only the distribution (shown below) of expenditures for all insured persons.

Although not realistic (does not influence results), assume an auctioneer attempts a first trial price of $0.

1. Who demands coverage at this price?
2. Because the insurance company does not know exactly how much each insured will spend, they will assume an average expenditure level for each insured. How much is the average expenditure level? How much is supplied at the initial price?
3. Suppose next, the auctioneer calls out a price = $1/2M. Who (potential insureds) leaves the market and chooses to self-insure (out of pocket)? What is the average expenditure level now? How much is supplied at the new price of $1/2M?
4. What are the main findings from this example? That is, in this market for insurance, who gets driven out of the market? Who drives them out of the market?

3. Suppose that instead of going to work one morning, Ellen decides go to the doctor for a 10-minute visit. It will take her 15 minutes to travel each way, 20 minutes to wait in the office, and 10 minutes with the doctor. Suppose further that the money cost of the visit is $25, and that her hourly wage is $10. Travel (gas etc.) and parking cost $5.

a. What is the full price of each visit?

b. Suppose Ellen demands six visits at this full price. Draw a graph of Ellen's demand for office visits where P equals the full price.

c. Suppose the money price of an office visit increases by $5, at which she demands five visits. On the same graph, illustrate this ordered pair.

d. Find the price elasticity of demand with respect to the full price using "arc elasticity," which evaluates the price at the midpoint between the beginning (1^st) and ending (2^nd) price, and similarly for quantity demanded.

e. Find the price elasticity of demand with respect to the money price using "arc elasticity."

f. Given your answers to d and e, does time price affect demand?

4. In your own words, what are the four factors that can cause a change in the demand for health stock? Using the MEI curve as the demand for health capital, show the effects of an increase in the wage rate on an individual's demand for health capital. Show how this increase in the wage rate can actually cause the amount of health stock demanded to be lower than before the wage rate increase. Why would this happen? Be sure to label everything on the graph and describe your work.