Ebook Microeconomics: Part 1

(BQ) Part 1 book Microeconomics has contents: Economics and life, specialization and exchange, markets, elasticity, efficiency, government intervention, game theory and strategic thinking, time and uncertainty, behavioral economics - a closer look at decision making,...and other contents.

www.downloadslide.com Get Connected FEATURES LearnSmart™ McGraw-Hill LearnSmart is an adaptive learning program that identifies what an individual student knows and doesn’t know LearnSmart’s adaptive learning path helps students learn faster, study more efficiently, and retain more knowledge Reports available for both students and instructors indicate where students need to study more and assess their success rate in retaining knowledge Graphing Tool The graphing tool within Connect Economics provides opportunities for students to draw, interact with, manipulate, and analyze graphs in their online auto-graded assignments, as they would with pencil and paper The Connect graphs are identical in presentation to the graphs in the book, so students can easily relate their assignments to their reading material Get Engaged eBooks Connect Plus includes a media-rich eBook that allows you to share your notes with your students Your students can insert and review their own notes, highlight the 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Smith, and Zimmerman Managerial Economics and Organizational Architecture Fifth Edition MONEY AND BANKING Cecchetti and Schoenholtz Money, Banking, and Financial Markets Third Edition URBAN ECONOMICS O’Sullivan Urban Economics Eighth Edition LABOR ECONOMICS Borjas Labor Economics Sixth Edition McConnell, Brue, and Macpherson Contemporary Labor Economics Tenth Edition PUBLIC FINANCE Rosen and Gayer Public Finance Tenth Edition Seidman Public Finance First Edition ENVIRONMENTAL ECONOMICS Thomas and Maurice Managerial Economics Eleventh Edition Field and Field Environmental Economics: An Introduction Sixth Edition INTERMEDIATE ECONOMICS INTERNATIONAL ECONOMICS Bernheim and Whinston Microeconomics Second Edition Appleyard and Field International Economics Eighth Edition Dornbusch, Fischer, and Startz Macroeconomics Twelfth Edition King and King International Economics, Globalization, and Policy: A Reader Fifth Edition Frank Microeconomics and Behavior Eighth Edition ADVANCED ECONOMICS Romer Advanced Macroeconomics Fourth Edition Pugel International Economics Fifteenth Edition MICROECONOMICS Dean Karlan Yale University and Innovations for Poverty Action Jonathan Morduch New York University With special contribution by Meredith L Startz Yale University and Innovations for Poverty Action MICROECONOMICS Published by McGraw-Hill Education, Penn Plaza, New York, NY 10121 Copyright © 2014 by McGraw-Hill Education All rights reserved Printed in the United States of America No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning Some ancillaries, including electronic and print components, may not be available to customers outside the United States This book is printed on acid-free paper RJC/RJC ISBN: 978-0-07-733258-7 MHID: 0-07-733258-X Senior Vice President, Products & Markets: Kurt L Strand Vice President, Content Production & Technology Services: Kimberly Meriwether David Managing Director: Douglas Reiner Executive Director of Development: Ann Torbert Development Editor: Alyssa Lincoln Director of Digital Content: Douglas A Ruby Digital Development Editor: Kevin Shanahan Digital Development Editor: Meg Maloney Marketing Manager: Katie White Hoenicke Director, Content Production: Terri Schiesl Content Project Managers: Marianne L Musni and Lori Koetters Senior Buyer: Debra R Sylvester Senior Designer: Matt Diamond Cover Image: Roman Samokhin/Shutterstock.com Lead Content Licensing Specialist: Keri Johnson Typeface: 10/12 Palatino Roman Compositor: Laserwords Private Limited Printer: R R Donnelley All credits appearing on page or at the end of the book are considered to be an extension of the copyright page Library of Congress Cataloging-in-Publication Data Karlan, Dean S Microeconomics / Dean Karlan, Yale University and Innovations for Poverty Action; Jonathan Morduch, New York University ; with special contribution by Meredith L Startz, Yale University and Innovations for Poverty Action.—First edition pages cm.—(the McGraw-Hill series economics) Includes index ISBN-13: 978-0-07-733258-7 (alk paper) ISBN-10: 0-07-733258-X (alk paper) Microeconomics I Morduch, Jonathan II Title HB172.K36 2014 338.5—dc23 2013018523 The Internet addresses listed in the text were accurate at the time of publication The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGrawHill Education does not guarantee the accuracy of the information presented at these sites www.mhhe.com –Dean and Jonathan dedication We dedicate this book to our families about the authors Dean Karlan Dean Karlan is Professor of Economics at Yale University and President and Founder of Innovations for Poverty Action (IPA) Dean started IPA in 2002, with two aims: to help learn what works and what does not in the fight against poverty and other social problems around the world, and then to implement successful ideas at scale IPA now works in over 45 countries, with 800 employees around the world Dean’s personal research focuses on using field experiments to learn more about how microfinance works and how to make it work better His research uses ideas from behavioral economics, and also covers fundraising, voting, health, and education In recent work, for example, he has studied the impact of microcredit on the lives of the poor, and has worked to create better financial products in the United States to help people manage debt Dean is also President and cofounder of stickK.com, a start-up that helps people use commitment contracts to achieve personal goals, such as losing weight or completing a problem set on time Dean is a Sloan Foundation Research Fellow, and in 2007 was awarded a Presidential Early Career Award for Scientists and Engineers He is coeditor of the Journal of Development Economics and on the editorial board of American Economic Journal: Applied Economics He holds a BA from University of Virginia, an MPP and MBA from University of Chicago, and a PhD in Economics from MIT In 2011, he coauthored More Than Good Intentions: Improving the Ways the World’s Poor Borrow, Save, Farm, Learn, and Stay Healthy Jonathan Morduch Jonathan Morduch is Professor of Public Policy and Economics at New York University’s Wagner Graduate School of Public Service Jonathan focuses on innovations that expand the frontiers of finance and how financial markets shape economic growth and inequality Jonathan has lived and worked in Asia, but his newest study follows families in California, Mississippi, Ohio, Kentucky, and New York as they cope with economic ups and downs over a year The new study jumps off from ideas in Portfolios of the Poor: How the World’s Poor Live on $2 a Day (Princeton University Press, 2009) which he coauthored and which describes how families in Bangladesh, India, and South Africa devise ways to make it through a year living on $2 a day or less Jonathan’s research on financial markets is collected in The Economics of Microfinance and Banking the World, both published by MIT Press At NYU, Jonathan is Executive Director of the Financial Access Initiative, a center that supports research on extending access to finance in low-income communities Jonathan’s ideas have also shaped policy through work with the United Nations, World Bank, and other international organizations In 2009, the Free University of Brussels awarded Jonathan an honorary doctorate to recognize his work on microfinance He holds a BA from Brown and a PhD from Harvard, both in Economics Karlan and Morduch first met in 2001 and have been friends and colleagues ever since Before writing this text, they collaborated on research on financial institutions Together, they’ve written about new directions in financial access for the middle class and poor, and in Peru they set up a laboratory to study incentives in financial contracts for loans to women to start small enterprises In 2006, together with Sendhil Mullainathan, they started the Financial Access Initiative, a center dedicated to expanding knowledge about financial solutions for the half of the world’s adults who lack access to banks This text reflects their shared passion for using economics to help solve problems, both in everyday life and in the broader world viii brief contents 10 Information Thinking Like an Economist 219 11 Time and Uncertainty 237 PART The Power of Economics 1 Economics and Life Specialization and Exchange PART Firm Decisions 255 25 12 The Costs of Production PART Supply and Demand 47 13 Perfect Competition 257 283 Markets 49 14 Monopoly Elasticity 15 Monopolistic Competition and Oligopoly 77 309 16 The Factors of Production Efficiency 99 Government Intervention 17 International Trade 123 337 365 399 Microeconomics: Thinking Like a Microeconomist PART Public Economics 427 PART Individual Decisions 153 19 Public Goods and Common Resources 457 Consumer Behavior 18 Externalities 429 20 Taxation and the Public Budget 155 475 Behavioral Economics: A Closer Look at Decision Making 179 21 Poverty, Inequality, and Discrimination 503 Game Theory and Strategic Thinking 23 Public Policy and Choice Architecture 555 193 22 Political Choices 535 ix 244 PART ■ Individual Decisions We can use expected value to make the analysis of the benefits of a college education a bit more realistic In reality, of course, you could follow countless possible career paths But for the sake of simplicity, let’s say there are just two possibilities open to you without a college degree Without a college degree, you have: • A 50 percent chance of a career in which you make $1.5 million over 30 years ($50,000 a year) • A 50 percent chance of making $900,000 over 30 years ($30,000 a year) Then suppose that getting a college degree opens up a new range of job options With a college degree, you have: • A 50 percent chance of making $2.4 million • A 25 percent chance of making $1.5 million • A 25 percent chance of making $900,000 Table 11-1 shows these possibilities We can’t know for sure which of these possible career paths will come true But since we know the probability of each, we can measure the expected value of your future income with and without college The general formula for the expected value of a decision is found by multiplying each possible outcome of an event (which we will call S) by the probability P of it occurring, and then adding together each of these terms for n different outcomes: Equation 11-5 Expected value EV (P1 S1) (P2 S2) (Pn Sn) Using this formula, we find that the expected value of your income without a college degree is: EV (50% $1,500,000) (50% $900,000) $1,200,000 Applying the same method to find the expected value of your income with a college degree, you get: EV (25% $1,500,000) (25% $900,000) (50% $2,400,000) $1,800,000 Unlike our earlier estimates, these figures incorporate the risk that your income might actually be lower with a college degree than it would have been without It’s always a possibility—you might get unlucky But since you cannot know ahead of time whether you will be lucky or not, you can still make a choice based on your expected income, which is $600,000 higher with a degree Expected value can be a useful tool for making decisions whenever future outcomes are uncertain For example, when investing in a retirement fund, you won’t know for certain how quickly that fund will grow, but calculating an expected value can help you to decide how much you need to be saving When choosing between different options, though, you won’t necessarily always want to choose the option with the highest expected value As we will see, you will also want to consider the worst-case outcome for each option, and decide whether the risk of the worst-case outcome is unacceptably high TABLE 11-1 Probability of outcomes Lifetime earnings by education level $0.9 million $1.5 million $2.4 million No college degree 50% 50%  0% College degree 25% 25% 50% Time and Uncertainty ■ CHAPTER 11 245 Propensity for risk LO 11.5 Explain how risk aversion makes a market for insurance possible Some things are riskier than others There’s a very low risk of injury when playing golf, for example, and a more significant risk when skiing Similarly, some things that you can with your money involve a higher risk of loss than others Putting your money in a savings account or government bonds carries a very low risk of loss; investing in a start-up company or playing the stock market usually carries a much higher risk People have different levels of willingness to engage in risky activities Those who generally have low willingness to take on risk are said to be risk-averse Those who enjoy a higher level of risk are risk-seeking These attitudes toward risk are an aspect of an individual’s preferences—as is a preference for a certain ice-cream flavor, or a preference to spend your spare income on clothes or concerts Although individuals have varying tastes for taking on financial risks, economists believe that people are generally risk-averse in the following sense: When faced with two options with equal expected value, they will prefer the one with lower risk Let’s say we run a competition, and you’re the winner As a prize, we offer you these options: Option A: We flip a coin Heads, and your prize is $100,001 Tails, and your prize is $99,999 Option B: We flip a coin Heads, and your prize is $200,000 Tails, and you get nothing at all Both options have an expected value of $100,000 (Try writing out this calculation to make sure.) When economists say that people are generally risk-averse, it implies that most people prefer option A, even though both options have the same expected value (Clearly, though, not everyone would choose option A If that was the case, nobody would ever go to a casino and take big chances by piling their bets on red or black on the roulette wheel.) To put it another way, the expected value of option B would have to be greater before most people would accept the risk of winning nothing If you chose option A, ask yourself how much would the value in option B have to rise to tempt you to switch to B? Perhaps to $250,000? (The expected value of option B would then rise to $125,000.) How about $1,000,000 (for an expected value of $500,000 for option B)? The answer depends on your personal taste for risk, and it will differ for each individual Although it may seem unlikely (alas) that you will ever win such a prize in a competition, this trade-off between risk and expected value is exactly the kind of choice you have to make whenever you think about investing money in stocks, retirement funds, bonds, or real estate ✓CONCEPT CHECK ❒ How is the expected value of a future event calculated? [LO 11.4] ❒ Why economists say that people tend to be risk-averse? [LO 11.5] Insurance and Managing Risk People cope with uncertainty about the future in many ways One approach is to simply avoid taking greater risks than are strictly necessary If you don’t want to risk hurting yourself while skiing, then don’t go skiing! But some risks in life are unavoidable, and some risky activities—like skiing—are avoidable but fun So people have also developed ways to manage the risks they face in their lives risk-averse having a low willingness to take on situations with risk risk-seeking having a high willingness to take on situations with risk Some people have different preferences for risk 246 PART ■ Individual Decisions One common way to manage risk is to buy insurance An insurance policy is a product that lets people pay to reduce uncertainty in some aspect of their lives For instance, if you enjoy skiing, you can buy insurance to cover the cost of being airlifted to a hospital if you break your leg in a fall on the slopes Insurance products usually involve paying a regular fee in return for an agreement that the insurance company will cover any unpredictable costs that arise The market for insurance You’ve probably encountered many types of insurance associated with common risks that people face in life There is auto insurance to manage the risk of having your car damaged or causing damage to someone else Medical insurance manages the risk of becoming ill or injured Homeowner’s or renter’s insurance manages the risk of having your belongings destroyed or stolen Companies that provide these insurance products collect a fee—called a premium—in return for covering the costs that clients would otherwise have to pay if they experienced any of these unfortunate events In general, the amount people pay for insurance is higher than its expected value For instance, suppose that you pay $1,000 per year for auto insurance Suppose also that in any given year there is a percent likelihood that you will get into an accident that costs $10,000, and a 0.1 percent likelihood of an accident that costs $200,000 If we assume that your insurance policy would cover the full cost of these accidents, then the expected value of coverage in any given year is $300: EV (1% $10,000) (0.1% $200,000) $100 $200 $300 Does paying $1,000 for something with a $300 expected value make people suckers? Not really Most people are risk-averse enough to find insurance worth the extra expense The $700 doesn’t go down the drain It buys the utility that comes from peace of mind, knowing that if you get into an expensive auto accident, you will not be ruined by the costs The reason people are generally willing to pay for insurance is that they would have trouble finding enough money to replace their homes and all of their possessions following, say, a fire, or to cover the cost of long-term hospital care if they fell ill Insurance allows people to feel confident that if they are suddenly faced with these huge expenses, they won’t face bankruptcy or be unable to pay for the services they need In fact, if the expected value of insurance policies were equal to the premiums paid, insurance companies would not stay in business very long: The insurers would be paying out approximately the same amount they received in premiums, with nothing left over The industry exists only because it can make a profit from the extra amount that people are willing to pay for the service of managing risk Some people are willing to pay for coverage of very unusual risks To read about some unusual insurance policies, read the From Another Angle box “Hole-in-one insurance?” FROM ANOTHER ANGLE Hole-in-one insurance? Auto, home, and medical insurance are some of the most common insurance products because they relate to risks that most people face However, insurance can be appropriate for anything that involves large and unexpected expenses, and markets have developed to cover some much more unusual risks, from insurance on body parts to insurance against the risk of hitting a hole in one in golf To learn more, continue reading by scanning the QR code near the end of the chapter or by going online Time and Uncertainty ■ CHAPTER 11 247 Pooling and diversifying risk LO 11.6 Explain the importance of pooling and diversification for managing risk Insurance does not reduce the risks inherent in life Having car insurance will not make you less likely to be in an accident (As we will see in the next section, it may actually make accidents more likely.) Instead, insurance works because it reallocates the costs of such an event, sparing any individual from taking the full hit This reallocation occurs through two mechanisms The first mechanism for reallocating risk is called pooling Risk pooling occurs when people organize themselves in a group to collectively absorb the cost of the risk faced by each individual This is the foundational principle that makes insurance companies work The company is able to easily absorb the cost of one person’s emergency, because at any given time, it will have many other clients who are paying their premiums and not making claims Suppose, for example, a company has 1,000,000 clients Putting aside the question of the company’s profits, this is equivalent to every client agreeing that he or she will pay of the cost of catastrophes that happen to other clients In return, all clients 1,000,000 999,999 have the assurance that they won’t have to pay of the cost if a catastrophe happens 1,000,000 to them Pooling doesn’t reduce the risk of catastrophes happening; it just reallocates the costs when they An example of risk pooling comes from the method used by the United Kingdom and other countries to pay for student loans Rather than making individual students responsible for the costs of their education, all students get their loans from a government-backed company That company must be repaid only if students earn enough money out of college to so You can read about the merits and problems of this system in the What Do You Think? box “Who should bear the risk that a college degree doesn’t pay off?” WHAT DO YOU THINK? Who should bear the risk that a college degree doesn’t pay off? Suppose you could buy insurance against the possibility that despite your college degree, you will never get a high-paying job: If your salary never rises above a certain level, the insurance company will pay off the loan you took out to go to college Would you be interested in buying such an insurance product? Actually, this is exactly the kind of student loan system in place in some countries, such as the United Kingdom Students borrow from a government-backed company and repay their loans only once they start earning above a certain amount If their earnings never reach that level, the loan is eventually written off Supporters of this system say it encourages more young people to go to college: Nobody needs to fear that by getting an education, they will incur debts that they will struggle to pay off Critics point out that taxpayers—including people who never went to college—end up subsidizing graduates who fail to get high-paying jobs Some people have proposed replacing this system with a “graduate tax.” Under this proposal, college education would be free, and paid for by levying an additional income tax on all college graduates earning above a certain sum Instead of asking all taxpayers to foot the bill for college, only people who attend college would be on the hook Effectively, this is a debate about who should bear the risk that a college education doesn’t pay off In the UK, it’s currently the taxpayers Under the graduate-tax proposal, the risk would be pooled among everyone who attends college In the U.S., the responsibility usually falls on the individual student or student’s family Should risk pooling  organizing people into a group to collectively absorb the risk faced by each individual others be required to pay for the education of people who decide to be social workers or poets? On the other hand, does society as a whole lose something by discouraging students from pursuing their passions for social services or the arts? What you think? Who should bear the costs of a college education for those people who not earn enough money to pay back their loans? Should the tuition for those who go into certain majors or professions be forgiven? If you think so, how should we choose which majors or professions should be chosen for this type of program? diversification the process by which risks are shared across many different assets or people, reducing the impact of any particular risk on any one individual The second mechanism for managing risk is diversification Risk diversification refers to the process by which risks are shared across many different assets or people, reducing the impact of any particular risk on any one individual Diversification is about not putting all your eggs in one basket, and it can be practiced by individuals or firms For instance, if you invest all of your money in one company, you are completely dependent on that company’s fortunes If it goes bankrupt, so will you Instead, many people choose to diversify by investing smaller amounts in many companies If one company fails, they will lose some money, but not all of it Like pooling your risks, diversifying your risks does not change the likelihood that bad things will happen It just means that you’re not going to be completely ruined by a single unfortunate event The key to diversification is that the risks should be as unrelated as possible For instance, suppose an insurance company sells only one type of insurance—home insurance against earthquakes in San Francisco This would not be a sensible way for homeowners in San Francisco to pool their risks because if one client’s home is destroyed by an earthquake, that same earthquake is likely to destroy many other clients’ homes as well The insurance company could face all of its clients making claims at once, and would go bankrupt In other words, the risk of earthquake damage to one home in San Francisco is highly correlated with the risk of earthquake damage to other homes in San Francisco (Remember that positive correlation means things tend to occur together.) To avoid this problem, the insurance company might choose also to sell, say, car insurance in New Jersey and hurricane insurance in Florida Earthquakes, car crashes, and hurricanes in different parts of the country are uncorrelated: None of them are more or less likely to occur if one of the others occurs The insurance company has diversified its risk by selling different products in different places If it has to pay out after an earthquake in San Francisco, those costs will be covered by the premiums it continues to collect in other places These days, you’re offered insurance quite often, whether on a new tennis racquet or a cell phone At the time, you have no idea whether it’s a good idea to buy it or not If the cell phone breaks, the insurance is totally worth it; if the phone lasts for years, you didn’t need insurance at all As “Hindsight is 20/20” in the From Another Angle box describes, though, it’s not best to look at a decision to buy insurance many years after the fact FROM ANOTHER ANGLE Hindsight is 20/20 Say you bought an extended warranty that guarantees the replacement of your washing machine if it breaks, and then the washing machine actually does break You might feel quite pleased with yourself Now imagine that after living in the Mississippi delta and paying flood insurance for 20 years, you move away without having experienced a single flood You might feel like you threw away your money Was the washing machine 248 warranty the right decision, and the flood insurance the wrong decision? Don’t be too hasty to draw that conclusion In both cases, the way things actually turned out has nothing to with whether the initial decision was a good one Decisions that seem right when you make them can seem horribly wrong in retrospect It’s tempting to think that you need the benefit of hindsight to judge whether a decision about the future was right But that’s the wrong way to think about such decisions You have to judge whether they were right or wrong by considering the best information available at the time In decisions about insurance, two pieces of information are crucial: How likely is the event you’re insuring against, and how catastrophic would it be if it happened? The Mississippi delta is quite likely to flood, and recovering from flood damage can be ruinously expensive So, buying flood insurance in this instance was probably the right decision, even if you didn’t end up using it On the other hand, flood insurance is probably not such a smart purchase if you live on the top of a hill in Denver—flood damage would be just as ruinously costly, but the likelihood is minuscule How about the washing machine? Suppose it costs $450, and the salesperson offers you insurance at $12.50 a month This comes to $150 a year, so if the washing machine works well for at least three years—which is quite likely—you’ve already saved enough to buy a new one If you’re unlucky and it does break down before then, it wouldn’t be a disaster: It would be annoying to have to fork out $450 for another washing machine, but it probably wouldn’t bankrupt you Unless you’re extremely risk-averse, refusing the insurance at that price is the right decision—even if it turns out that the washing machine then breaks down in its second year After the fact, the uncertainty about the future that drove you to buy insurance has been resolved But that doesn’t mean that you should second-guess your decisions If your hilltop Denver home suffers damage in a flash-flood, you’re an unlucky person— but you didn’t necessarily make the wrong decision about whether or not to buy flood insurance Problems with insurance LO 11.7 Describe the challenges that adverse selection and moral hazard pose for insurance Managing risks by pooling and diversifying them sounds great There are two big problems, however: adverse selection and moral hazard Although we discussed these ideas at length in the “Information” chapter, they are particularly crucial for thinking about insurance and risk management The first problem insurance companies face is adverse selection This concept describes a state that occurs when buyers and sellers have different information about the quality of a good or the riskiness of a situation, and this asymmetric information results in failure to complete transactions that would have been possible if both sides had the same information In the context of insurance, adverse selection refers to the tendency for people with higher risk to be drawn toward insurance For example, in car insurance, the hidden information is that insurers don’t know who the bad drivers are, and the unattractive good is an insurance policy on a reckless driver If you know you’re a terrible driver, you’re going to try to buy as much car insurance as you can; if you smoke, live on fast food, and not exercise, you might be an enthusiastic customer for health insurance, and so on If insurance companies knew everything about their clients, adverse selection would not be a problem The insurers would simply charge higher premiums to higher-risk clients Insurance companies can and ask potential clients seemingly endless questions about their driving records, smoking habits, and so on But the clients still often know adverse selection a state that occurs when buyers and sellers have different information about the quality of a good or the riskiness of a situation; results in failure to complete transactions that would have been possible if both sides had the same information 249 250 moral hazard the tendency for people to behave in a riskier way or to renege on contracts when they not face the full consequences of their actions PART ■ Individual Decisions much more about their relevant risk factors than the insurance company The result is that insurers have a hard time accurately assessing how risky a particular customer will be and charging the right price To cover their costs, insurance companies usually end up charging higher prices to all customers That decision can make insurance a much less good deal for low-risk individuals If not kept in check, adverse selection can make it hard for less-risky individuals to find an insurance contract that’s worth buying The second problem is moral hazard—the tendency for people to behave in a riskier way or to renege on contracts when they not face the full consequences of their actions If your car is insured against theft, for example, you may be more relaxed about parking it in an unsafe-looking neighborhood This problem is especially acute with medical insurance: People who know that their medical costs are covered may demand treatments and tests that they would never purchase if they had to pay for them on their own In these cases, insurance can actually increase the expected cost of risks, as discussed in the What Do You Think? box “Should health insurance include preventive care?” WHAT DO YOU THINK? Should health insurance include preventive care? One of the highest-profile political debates in America is about how to rein in the steadily increasing costs of medical care Skyrocketing medical expenditures have been attributed to many factors, including the increased prevalence of obesity, an aging population, and steadily rising malpractice liabilities for doctors One strategy that many have suggested to rein in costs is to increase the incentives for people to seek preventive care With many diseases—including cancer and diabetes, two of the costliest to treat—spending money on early detection and preventive care can prevent much higher costs from being incurred down the road Preventive care can also reduce the suffering that comes with chronic illness On the other hand, moral hazard comes into play If people with medical insurance are entitled to preventive care, they may demand all kinds of expensive tests and preventive treatments that they really don’t need Some people worry that this increase in spending might negate the benefit of future savings What you think? Should government policy encourage insurance companies to cover preventive care? Should insurance companies be able to choose which procedures they cover? ✓CONCEPT CHECK ❒ Why are people often willing to pay more for insurance than the expected value of the coverage? [LO 11.5] ❒ What’s the difference between risk pooling and risk diversification? [LO 11.6] ❒ Why can moral hazard increase the costs of insurance coverage? [LO 11.7] Conclusion Some of life’s most important decisions involve weighing uncertain future costs and benefits against costs and benefits today In this chapter, we looked at tools that can help with these decisions Interest rates enable you to compare apples to apples when you think about costs and benefits that occur at different times Expected value can help you think about what is the best option given uncertainty Managing risk through pooling or diversification can allow you to avoid bearing the full cost of a worst-case scenario if it happens Mobile Window on the World—Scan this code with your smartphone to find more applications of the chapter content (Need a barcode reader? Try ScanLife, available in your app store.) Visit your mobile app store and download the Karlan and Morduch Study Econ app Key Terms interest rate, p 239 expected value, p 243 diversification, p 248 compounding, p 240 risk-averse, p 245 adverse selection, p 249 present value, p 241 risk-seeking, p 245 moral hazard, p 250 risk, p 243 risk pooling, p 247 Summary LO 11.1 Explain why money is worth more now than in the future, and how the interest rate represents this relationship Money is worth more in the present than in the future because it can be immediately spent or invested in productive opportunities The interest rate is the cost of borrowing money for a certain unit of time It is usually expressed as a percentage per time period The interest rate is the amount needed to compensate the lender for the opportunity cost of loaning out money— in other words, the amount of money the lender could have earned from investing in something else if he or she weren’t lending it LO 11.2 Calculate compounding over time with a given interest rate Compounding is the process of accumulation that results from the additional interest paid on previously earned interest With compound interest, the amount of interest earned increases each period, since interest payments earned in the past themselves accumulate interest in future periods We calculate the future value of a sum of money, including compound interest, as FV 5 PV 3 (1 1 r)n LO 11.3 Calculate the present value of a future sum Present value refers to how much a certain amount of money in the future is worth today It can be calculated by rearranging the formula for the future value FV of a sum, to PV  5  _ Translating cost or benefits (1  1  r)n that occur at different times into their present value gives you a common unit of value, allowing you to compare apples to apples LO 11.4 Evaluate the costs and benefits of a choice using expected value Risk exists with uncertainty about the future—the possibility that things won’t turn out as you expect In order to understand the likely value of a choice with multiple possible outcomes, we calculate its expected value Expected value is the average of all possible future values, weighted by their probability of occurring Expected value allows us to account for risk when comparing options LO 11.5 Explain how risk aversion makes a market for insurance possible People have varying degrees of willingness to take on risk Those who have a high willingness to take on risk are known as risk-seeking; those with a low willingness to take on risk are risk-averse People are generally risk-averse in the limited sense that when two choices have the same expected value, they will prefer the less risky one This tendency is explained by the concept of diminishing marginal utility: The loss of utility caused by losing a large sum is greater than the benefit of gaining the same amount Insurance is a common strategy for managing risk An insurance policy lets people pay to reduce uncertainty in some aspect of their lives Such products usually involve paying a regular fee (premium) in return for an agreement that someone else will cover any unpredictable costs that arise Insurance does not reduce the risk of something bad happening; it simply guarantees that the cost of the event to the insured person will be low Risk aversion makes a market for insurance profitable: People are willing to pay to shield themselves from the cost of bad things happening, above and beyond the actual expected cost of those things 251 LO 11.6 Explain the importance of pooling and diversification for managing risk Risk pooling is a strategy for managing risk that involves many people organizing themselves in a group in order to collectively absorb the cost of the risk faced by each individual Risk pooling doesn’t decrease the risk that a bad event will occur; it only reduces the cost to a particular individual in the event that it does occur Diversification is another strategy for managing risk that involves replacing large risks with smaller unrelated ones That way, the cost of failure for any one investment is not so great, and the chance of many different investments all failing together is small, so the risk of losing a large amount is reduced Like pooling, diversification does not change the likelihood that bad things will happen; it just reduces the costs associated with any single event LO 11.7 Describe the challenges that adverse selection and moral hazard pose for insurance One challenge faced by insurance schemes is adverse selection—the tendency for people with higher risk to be drawn toward insurance If insurance companies were able to accurately identify risky clients, adverse selection would not be a problem; insurers would simply charge more for higher-risk clients But clients often know much more about their relevant risk factors than the insurance company does Moral hazard is another challenge for insurance companies Moral hazard means that people will behave in a riskier way when they know that their risks are covered by insurance Review Questions Anna is indifferent between receiving $200 today or $230 in a month What does this imply about her opportunity cost in the coming month? How much interest would Anna need to charge to lend $200 for the month in order to break even? [LO 11.1] Colton has a choice between $100 today and $150 in three months Farah has a choice between $100 today and $125 in three months Colton chooses $100 today Farah chooses $125 in three months Explain why Farah is the one who delays payment even though Colton stands to earn more by waiting [LO 11.1] Suppose your aunt invests $2,000 for you You are not allowed to have the money until the original 252 amount doubles Your aunt’s investment earns 10 percent, compounded annually Give a rough estimate of how long it will take before you can access the money your aunt invested for you [LO 11.2] You are considering taking out a two-year loan of $1,000 from a bank, on which you can pay either compound yearly interest of percent or a flat rate of percent for the whole two-year period Which option is a better deal, and why? [LO 11.2] Suppose you know that an investment will earn a positive return in the future Why is it important to know the present value of the investment? [LO 11.3] Suppose you are selling a piece of furniture to a friend who can’t afford to pay you upfront but offers to pay you in monthly installments for the next year What information you need to calculate the present value of this offer? (Hint: Think about the formula for present value.) [LO 11.3] A pharmaceutical company is considering investing in the development of a new drug The company stands to make a lot of profit if the drug is successful However, there is some risk that the drug will not be approved by government regulators If this happens, the company will lose its entire investment Advise the company how to take this risk into account as managers evaluate whether to invest [LO 11.4] You have a big exam tomorrow You were planning to study tonight, but your friend has tickets to a concert and has invited you to join her You would be willing to accept a B on the exam in order to go to the concert You estimate that if you don’t study you have a 35 percent chance of scoring a 90, a 35 percent chance of scoring an 80 (the score required to earn a B), a 25 percent chance of earning a 75, and a percent chance of earning a 60 Will you go to the concert? Explain why or why not [LO 11.4] Alie is outraged when she hears that a company is offering insurance against being attacked by zombies: “Zombies aren’t even real! This company is just taking advantage of people.” Without acknowledging the possible existence of zombies, provide an alternative perspective on the insurance company’s ethics [LO 11.5] 10 Julia pays $500 for an insurance policy with an expected value of $120 Explain why this is a rational choice for Julia [LO 11.5] 11 Suppose that the crop yield of corn farmers in Iowa depends solely on rainfall levels Also suppose that every part of the state gets approximately the same amount of rain as every other part in any given year Will the corn farmers of Iowa be able to effectively use pooling to reduce their exposure to risk? Why or why not? [LO 11.6] 12 An insurance company that faces fierce competition from other providers is considering a strategy to sell more policies by simplifying its portfolio and becoming the expert in flood insurance for the state The company managers reason, “Everyone buys flood insurance in this state, so let’s focus our efforts on becoming the preferred provider.” Evaluate this strategy [LO 11.6] 13 Suppose the economy is suffering and many people are afraid they will be laid off from their jobs Workers would like to protect against this risk with insurance Identify and explain two problems that prevent insurance companies from offering layoff insurance [LO 11.7] 14 BackPedal is a bike-rental shop that rents bicycles, helmets, and other gear by the day [LO 11.7] a BackPedal offers an optional helmet rental for $10/day with the rental of a bicycle To his surprise, the store manager has noticed that cycling accidents are higher among customers who rent helmets than those who not Explain this phenomenon using economic concepts Assume that customers who not rent helmets also not own helmets b BackPedal is considering offering helmets for free with a bike rental Explain how this new policy will affect the issues you identified in part a Problems and Applications Your bank offers percent annual interest on savings deposits If you deposit $560 today, how much interest will you have earned at the end of one year? [LO 11.1] You have $350, which a friend would like to borrow If you don’t lend it to your friend, you could invest it in an opportunity that would pay out $392 at the end of the year What annual interest rate should your friend offer you to make you indifferent between these two options? [LO 11.1] If you deposit $500 in a savings account that offers percent interest, compounded annually, and you don’t withdraw any money, how much money should you expect to have in the account at the end of three years? [LO 11.2] Suppose you run up a debt of $300 on a credit card that charges an annual rate of 12 percent, compounded annually How much will you owe at the end of two years? Assume no additional charges or payments are made [LO 11.2] Your savings account currently has a balance of $32,300 You opened the savings account two years ago and have not added to the initial amount you deposited If your savings have been earning an annual interest rate of percent, compounded annually, what was the amount of your original deposit? [LO 11.3] You run a business and are considering offering a new service If you offer the new service, you expect it to generate $60,000 in profits each year for your business over the next two years In order to offer the new service, you will need to take out a loan for new equipment Assume a percent annual interest rate [LO 11.3] You are driving home from work, and get stuck in a traffic jam You are considering turning off from your usual route home and taking a longer route that might have less traffic However, you know that there is some chance that the traffic on your usual, shorter route will clear up Based on Table  11P-1, calculate the expected value (in minutes until you arrive home) of each option [LO 11.4] Books for Kids is a not-for-profit organization that runs after-school reading programs in four school districts Books for Kids is planning a fundraiser to buy new books Last time it held a fundraiser, donors were allowed to specify which district program they wanted to receive their donation Table  11P-2 shows the average donations and the TABLE 11P-1 Probability of encountering on Route Light traffic Moderate traffic Heavy traffic 30% 20% 50% 30 minutes 60 minutes 50% 0% 40 minutes 80 minutes Duration of drive 10 minutes on Route Probability of encountering on Route 50% Duration of drive 20 minutes on Route 253 TABLE 11P-2 c Neighboring farmers who grow the same crop, which is prone to failure in dry years Average donation ($) Percent of donations (%) Northwest district 25 15 Southeast district 50 30 West district 15 20 South district 12 35 percent of all donations that went to each district Using the last fundraiser as a projection, what is the expected value of the average donation across all four programs? [LO 11.4] Cora had two options when buying car insurance Option A had a higher expected value, but Cora chose option B From the list below, what can we assume about these policies and Cora’s willingness to take on risk? Check all that apply [LO 11.5] a Option B was riskier b Option A was risker c Cora is risk-seeking d Cora is risk-averse 10 You are considering buying one of two types of health insurance You guess that in the next year there is a percent chance of serious illness that will cost you $67,500 in health care; a percent chance of a moderate illness that will cost you $2,500; and a 90 percent chance of regular health care needs that will cost you $500 One type of health insurance is emergency-only coverage; it will cover your expenses for serious illness but not moderate illness or regular care The other type covers moderate illness and regular expenses, but its payout is capped, so it will not cover the cost of a serious illness [LO 11.5] a What is the expected value of payouts from the emergency-only insurance? b What is the expected value of payouts from the capped-coverage insurance? c Which is the more risk-averse option? 11 For each of the following scenarios, say whether pooling or diversification is a more promising riskmitigation strategy [LO 11.6] a Employees of a company who receive their salaries and health insurance from their employer and also invest their savings in that company’s stocks b Families who are worried about losing their possessions if their houses burn down 254 12 You have two possessions you would like to insure against theft or damage: your new bicycle, which cost you $800, and a painting you inherited, which has been appraised at $55,000 The painting is more valuable, but your bicycle must be kept outdoors and is in much greater danger of being stolen or damaged You can afford to insure only one item Which should you choose? Why? [LO 11.6] 13 Say whether each of the following scenarios describes an insurance problem caused by adverse selection or by moral hazard [LO 11.7] a People who have homeowners insurance are less likely than others to replace the batteries in their smoke detectors b People who enjoy dangerous hobbies are more likely than others to buy life insurance c People whose parents died young are more likely than others to enroll in health insurance d People who have liability coverage on their car insurance take less care than others to avoid accidents 14 Requiring every American to get mandatory health care insurance has been a controversial part of health care reform debates in the United States Putting aside other arguments for or against mandatory coverage, would this policy reduce adverse selection, moral hazard, both, or neither? [LO 11.7] Chapter Endnotes B Greene, “Obama, Romney Agree on Extending Student Loan Interest Rate Cut,” U.S News and World Report, April 23, 2012, http://www.usnews com/news/articles/2012/04/23/obama-romney -agree-on-extending-stafford-interest-rate-cut Ibid H Yen, Associated Press, cited in U.S News and World Report, April 23, 2012, http://www.usnews com/news/articles/2012/04/23/obama-romney -agree-on-extending-stafford-interest-rate-cut The reason the superscripts in the denominators in the computation begin with is that in the example, you don’t start earning your salary until year 5—that is, after college is over Chapter Sources http://professionals.collegeboard.com/profdownload/ cb-policy-brief-college-stu-borrowing-aug-2009.pdf http://www.census.gov/prod/2002pubs/p23-210.pdf Appendix Math Essentials: Compounding F LEARNING OBJECTIVES LO F.1 Use compounding to calculate time value of money Compounding LO F.1 Use compounding to calculate time value of money In Chapter 11, you learned how to compute the future value of money using compound interest Compounding occurs because the interest your money earns in one time period itself earns interest in the next time period Multiplying a single investment by an interest rate is simple enough, but calculating the growth of an investment over time is more complicated, because the base keeps changing In every period, we have to multiply the interest rate by the initial investment plus any interest earned in earlier time periods Future Value Let’s say that you invest $100 right now at an interest rate of 10 percent You plan to withdraw your money in four years, and the interest compounds annually What will be the value of your investment in four years? Let’s first calculate the value year by year, accounting for the compounding interest This calculation is essentially calculating percentage change The 10 percent in interest represents how much the original amount you invest will change in one time period (in this case, one year) Year 1: $100.00 ($100.00 0.10) $110.00 Year 2: $110.00 ($110.00 0.10) $121.00 Year 3: $121.00 ($121.00 0.10) $133.10 Year 4: $133.10 ($133.10 0.10) $146.41 Notice that each year we incorporate the interest earned in the previous year into the base investment for the next year In other words, we multiply the interest rate not by the initial investment, but by the initial investment plus any previously earned interest Instead of these year-by-year calculations, we can use a formula The general formula for computing the future value of money using compounding is: Equation F-1 Future value FV PV (1 r)n 254A 254B PART ■ Individual Decisions PV is the amount (present value) of the initial investment, FV is the future value of the investment, r is the interest rate, and n is the number of time periods between now and the future Let’s try the problem again using the formula for compound interest First, remember the order of operations: PEMDAS P: Parentheses, from the innermost outward E: Exponents MD: Multiplication and Division from left to right AS: Addition and Subtraction from left to right Therefore, we plug in your initial investment of $100 for PV1 and the time period of 4 years for n, and solve for FV in the following order (Hint: You might want a calculator for this.) FV PV (1 r)n FV 100 (1 0.1)4 FV 100 (1.1)4 (Remember to start with the operations inside the parentheses.) FV 100 1.4641 (Now you apply the exponent.) FV $146.41 After four years, your investment of $100 will be worth $146.41 Let’s see how the problem changes when we change the interest rate This time, let’s calculate the future value of your $100 investment if the interest rate is percent We will still invest for four years with interest compounded annually Year 1: $100.00 ($100.00 0.05) $105.00 Year 2: $105.00 ($105.00 0.05) $110.25 Year 3: $110.25 ($110.25 0.05) $115.76 Year 4: $115.76 ($115.76 0.05) $121.55 Now, let’s the problem again using the formula FV 100 (1 0.05)4 FV 100 (1.05)4 FV 100 1.2155 FV $121.55 After four years, your investment of $100 is worth $121.55 This same method can be used to calculate the value of a borrowed sum of money, as well as an invested one Instead of an initial investment, we can plug in the initial amount borrowed The interest rate is the rate at which the debt increases, rather than the rate at which your investment grows; otherwise the calculations are exactly the same Suppose you borrow $1,000 at a monthly interest rate of 10 percent, and wait for five months to pay it off Let’s assume that interest is compounded monthly How will your debt accumulate each month? Month 1: $1,000.00 ($1,000.00 0.10) $1,100.00 Month 2: $1,100.00 ($1,100.00 0.10) $1,210.00 Math Essentials: Compounding Month 3: $1,210.00 ($1,210.00 0.10) $1,331.00 Month 4: $1,331.00 ($1,331.00 0.10) $1,464.10 Month 5: $1,464.10 ($1,464.10 0.10) $1,610.51 ■ APPENDIX F 254C Let’s the problem again using the formula FV 1,000 (1 0.1)5 FV 1,000 (1.1)5 FV 1,000 1.61051 FV 1,610.51 After five months, you will owe $1,610.51, or more than one and a half times your initial debt Problems and Applications If you invest $250 at an annually compounded interest rate of 10 percent, how much will you have in years? [LO F.1] Suppose you invest $500 at an annually compounded interest rate of percent [LO F.1] a How much will you have in 10 years? b How much will you have in 20 years? c How much will you have in 50 years? Suppose you borrow $50 from a payday lender, who charges a monthly interest rate of percent, compounded monthly [LO F.1] a If you pay back the loan in one month, how much will you owe? b If you pay back the loan in one year, how much will you owe? c If the interest rate is raised to percent rather than percent, how much more will you owe if you wait for a year to pay off the debt? This page intentionally left blank ... contents 10 Information Thinking Like an Economist 219 11 Time and Uncertainty 237 PART The Power of Economics 1 Economics and Life Specialization and Exchange PART Firm Decisions 255 25 12 The... Government Intervention 17 International Trade 12 3 337 365 399 Microeconomics: Thinking Like a Microeconomist PART Public Economics 427 PART Individual Decisions 15 3 19 Public Goods and Common... economics) Includes index ISBN -13 : 978-0-07-733258-7 (alk paper) ISBN -10 : 0-07-733258-X (alk paper) Microeconomics I Morduch, Jonathan II Title HB172.K36 2 014 338.5—dc23 2 013 018 523 The Internet addresses