Teaching Assistants names and code:

1

• Teaching Assistants names and code
• Robert Mackay 066
• Steven Fies 145
• Aaron Schroeder 122
• Jaime Lynn Thomas 035
• Instructors name Lei Meng

2
Econ 2

• My office hour on this Friday (5 Dec) postponed
  to 1230 to 130 pm.
• Steven Fiess office hour on this Friday
  postponed to 630 to 830 pm.
• Review session
• 12/08/08 M 0400 to 0520 PM YORK 2622
• 12/09/08 T 0300 to 0350 PM CENTR 119
• Practice problems for Ch 18, 19, and 20 and the
  answer key have been posted.
• Office hours during the final week
• Steven Mon from 6 7 pm SH 231
• Robert Wed from 9 10 am SH 226
• Aaron Wed from 1 2 pm SH 207
• Jaime Thursday from 9-11 am SH 238
• Lei Thursday from 230 to 430

3
A 50 chance of winning 20 50 chance of
winning 200
U (EV of the lottery) is greater than the EU of
the lottery
The expected value of the lottery is EV ½
20 ½ 200 10100 110
Utility
30
B Sure pay of 110.
U (110) 25 utils
The expected value of a sure pay of 110 is EV
110
EU (lottery) ½ 10 ½ 30 20 utils
What would a risk averse person choose?
10
Choose B
20
200
110
Wealth
Given the same expected value, a risk averse
person will prefer the sure pay to the gamble
4
If your wealth is 65 and you bear no risk, your
utility is 20 utils
If you have 50 chance of winning 20 and
50 chance of winning 200, your expected wealth
is 110, but your expected utility remains at 20
utils
Utility
30
20 utils
So you are indifferent between these two
alternatives
10
Cost of risk
20
200
65
110
Wealth
If you are risk averse and you are indifferent
between a sure pay and a lottery, it must be the
case that the expected value from the lottery is
greater than the amount of the sure pay.
5
Market for Used Cars

• Without dealer warranties,
• only lemons are actually being traded in the
  used car market
• - Adverse selection exists
• Dealer warranties, however,
• break the lemon problem
• The warranty sends a signal to buyers,
  helping them avoid lemons
• Buyers believe the signal because the cost of
  sending a false signal is high

6
Market for Loans

• Suppose only 2 classes of borrowers low-risk
  (seldom default) and high-risk (frequently
  default)
• Banks want to charge two separate interest rates
  to each type of borrower
• But banks cannot always successfully separate
  low-risk borrowers from high-risk borrowers

7
Market for Loans

• Suppose banks charge the same interest rate to
  both types
• At the low-risk interest rate borrowers face
  moral hazard, banks attract a lot of high-risk
  borrowers adverse selection. At the end, most
  borrowers will default, banks would make a loss
• At the high-risk interest rate, most low-risk
  borrowers are unwilling to borrow

8
Market for Loans

• What do banks do in face of moral hazard and
  adverse selection?
• Banks use signals to discriminate between
  borrowers
• e.g. length of time on the job, marital status,
  ownership of a home, age, business record, and
  other variables correlate with being a low-risk
  borrower
• Banks also ration the sizes of the loans they
  make, so excess demand for loans exists.
• But most unsatisfied borrowers are the high-risk
  borrowers, making it not profitable for the banks
  to increase loans

9
Market for Insurance

• Moral hazard occurs when
• insured people have less incentive to be
  careful and avoid risky behavior
• Adverse selection arises because
• people who are of the high-risk type are more
  likely to buy insurance

10
Market for Insurance

• Moral hazard occurs when
• insured people have less incentive to be
  careful and avoid risky behavior
• Deductibles, where the insured person also must
  pay part of the expense of an incident, can
  reduce the moral hazard problem.
• Another device used is the no-claim bonus, the
  greater the bonus, the greater is the incentive
  to drive safely
• Adverse selection arises because
• people who are of the high-risk type are
  more likely to buy insurance
• Insurance companies seek out signals, e.g.,
  driving record, age, marital status, etc., to
  limit the extent of the adverse selection problem

11
International Trade

• Key idea
• Trade patterns are determined by comparative
  advantage, not absolute advantage.

12

• Suppose we have the following information about
  the productivity of industry in Japan and Korea.
• The data are the units of output produced by a
  worker per hour

13

• So a Japanese worker can produce 6 units of steel
  or 3 units of TVs per hour
• A Korean worker can produce 8 units of steel or 2
  units of TVs per hour
• We say that Japan has an absolute advantage in
  producing TVs and Korea has an absolute advantage
  in producing steel

14

• Lets plot the production possibilities frontier
  (PPF) for each country
• Without trade, the PPF is the consumption
  possibilities frontier, too.
• Note The slope of the PPF (in absolute value) is
  the opportunity cost of producing one unit of the
  good represented by the horizontal axis.

15

• The opportunity cost of producing one unit of TV
• Japan 2 units of steel
• Korea 4 units of steel
• Since the opportunity cost of a TV is lower in
  Japan, we say that Japan has a comparative
  advantage in TV production and should specialize
  in TVs
• The opportunity cost of producing one unit of
  steel
• Japan 1/2 unit of TV
• Korea ¼ unit of TV
• Since the opportunity cost of a steel is lower in
  Korea, we say that Korea has a comparative
  advantage in steel production and should
  specialize in steel

16

• Trade allows countries to specialize.
• After trade, countries consume outside their
  individual PPFs.
• In this way, trade is like an improvement in
  technology. It allows countries to move beyond
  their current PPFs.

17

• Only comparative advantage matters
• Absolute advantage is irrelevant in setting the
  pattern of trade