ECON 356

Homework Assignment Four

Due Tuesday, Oct. 26 at the beginning of class.  Homework turned in after I have collected it from the class will be considered late.

Directions:  Copy and paste this into a word document and then type your answers.  Graphs do not have to be typed.

(33 pts.)

1.  Suppose you are trying to determine whether a "lemons problem" exists in the market for used pickup trucks.  Explain why each of the following tests would or would not reveal a lemons problem.  So each of your answers should start with "this would (or would not) reveal a lemons problem because....." (2 pts. each)

a.  The percentage of pickup trucks that trade in the first year.

b.  The percentage of pickup trucks sold to dealers by the original owners is increasing over time.

c.  The maintenance cost of trucks after they are sold by the original owners is greater than the maintenance costs of pickup trucks that original owners retain.

2.  It is said (theoretically) that a market may not even exist when there is a lemons problem.  Using a supply and demand model, show how this can occur (again, theoretically). I just need the graph here.  Think!!  (4 pts.)

3.  Assume there are two insurance companies:  A and B.  Insurance company A practices statistical discrimination and Insurance company B does not (meaning that Insurance company B charges the same premium price to everyone with the same kind of insurance).  Insurance company A, on the other hand, charges higher rates to people who are members of certain groups - for example teenage males, people who live in high crime areas, etc..

a.  Given the theory we talked about in class -- which insurance company will most likely remain in business and which one will most likely have to close its doors and why? (5 pts.)

b.  Now assume that the government decides that statistical discrimination is not fair and prohibits it by law.  Therefore, all insurance companies are forced to offer a single rate.  What do you think will happen in the insurance industry? Assume that all insurance companies offer different kinds of insurance -- each kind (auto, home, accident, etc.) has a single rate.  (Hint:  remember, the government is forcing companies to offer a single rate, but it is not forcing them to offer insurance to everyone).  Back up your answer!!  (5 pts.)

4.  Can you think of a pricing scheme that insurance companies might use that would decrease moral hazard?  In your answer, explain what moral hazard is, what your pricing scheme is, and how/why it would decrease moral hazard.  (6 pts.)

5.  According to Coase, we see firms because it is often cheaper to organize inputs using vertical integration rather than by using the market (or the price mechanism).  Explain why and give an example.  (4 pts.)

6.  Explain, using Stigler's theory of vertical integration, why a small town with a relatively low average income level would not have a specialized store like a wine bar. (3 pts.)