This Document Contains Chapters 19 to 20 Chapter 19: Factor Markets and the Distribution of Income What’s New in the Fifth Edition? • Updated business cases Chapter Objectives • Explain how factor markets determine the distribution of income. • Explain how the demand for factors leads to the marginal productivity theory of income distribution. • Discuss the sources of wage disparities between women and men, and among different racial and ethnic groups. • Explain how the worker’s decision to allocate time between work and leisure gives rise to the labor supply curve. The Economy’s Factors of Production Creating Student Interest • Ask students why they chose to go to college (perhaps have them list their top reason[s] on a sheet of paper and collect them). Some answers will involve the utility gained from the educational experience. Many of the reasons students cite will relate directly to the creation of human capital. Go through some of the reasons and point this out. How and why do people invest in human capital? (To increase earnings.) Remind students that human capital includes experience as well as education. Internships have become an important way for students to gain experience and increase their human capital. (See the websites listed at the end of this chapter to find information on how education and internships affect earnings of college students.) Also point out that employers invest in their workers’ human capital—ask students how and why employers do this. This is an excellent opportunity to help beginning college students plan for and select their first jobs. Presenting the Material • Begin by reviewing the four classes of factors of production: land, labor, physical capital, and human capital. Emphasize that land refers to a resource provided by nature—and not merely to the ground/soil. Land includes natural resources on top of the ground, such as water or trees, as well as natural resources under the ground like oil and coal. Labor is the work of human beings, and must be distinguished from human capital, which is the improvement in labor created by education and knowledge. Finally, physical capital refers to goods used to produce other goods and services—such as equipment and machines. To make sure students understand this distinction, ask them if a pickup truck is considered capital. The answer is, “it depends.” If the truck is used recreationally for enjoyment, it is a consumption good, not capital. If the truck is used by a construction company to transport materials to building sites, it is considered capital. • Remind students of the terms for the payments to factors of production. Rent is paid for land, wages are paid to labor, and interest is paid for capital. It is useful to explain that interest is the payment for capital; if you had to borrow from a bank to buy capital (e.g., to build a factory) you would have to pay interest on the loan. A firm may have cash and not need to borrow to build a factory—but in that case the firm gives up earning interest on the cash they choose to spend building a factory. The interest in that case is the opportunity cost of investing in capital. Either way, interest is the price of capital. Use text Figure 19-1 to illustrate the importance of labor as a factor of production. More than 65% of income in the United States goes to labor. If we understand the labor market, we understand a great deal about factor markets in general. Marginal Productivity and Factor Demand Creating Student Interest • Have students brainstorm about what influences how much a person earns. You may need to remind them to consider characteristics of the market in which a person works as well as personal characteristics. • Have students imagine they own a business and are trying to decide if they should hire another worker. Make a list of variables that should be considered. Students are likely to identify the wage that must be paid, and will say something about the productivity or output of the worker. This example should get them to think about hiring a worker in terms of marginal benefit and marginal cost. • Have students imagine it is 10 years later and they have a full-time job. Ask them why their employer might give them a raise? Some students may correctly infer that raises are tied to performance, or productivity. You can also discuss cost-of-living increases. This example should help students understand the marginal productivity theory of income distribution, or the idea that factors of production are paid a wage (or rental rate) that depends on the marginal product of the last unit hired. • Now ask students what makes a worker more productive? Possible answers include training, experience or learning by doing, education, and better equipment or technology. Someone is also sure to suggest more money. Point out to students that more money (a wage increase or a bonus) can give a worker an incentive to work harder, but there is a limit to how much extra output the worker is capable of producing with the same equipment, technology, and level of human capital. Presenting the Material • The derivation of labor demand in this section assumes perfect competition, so be sure to remind students of the key assumptions of a perfectly competitive market. Each firm will take the price of the output and the wage of the worker as given. If a firm is hiring service workers and the going wage rate is $9 per hour, then this is what they will pay. They cannot charge less and still attract workers. They do not have to pay more than $9 if that is what others are paying. • Discuss the difference between average product and marginal product. Each worker in the end is paid a wage that is equal to the marginal product of the last worker hired. The average product will be higher than the marginal product of the last worker hired. Although the firm is willing to hire and pay each worker a wage that is equal to their respective marginal product, they do not have to do this. The extra gains go to the firm in terms of profit, or producer surplus. You might remind students that firms also sell all units for the same price although the marginal cost of producing each unit may vary. • Use Handout 19-1 to help the students think about the demand for labor, marginal productivity, and value of marginal product. Is the Marginal Productivity Theory of Income Distribution Really True? Creating Student Interest • Ask students what the following statistics tell us: 1. Women on average earn 72 cents for each dollar a man earns. 2. Hispanic men with a college degree earn on average about 90% more than Hispanic men who do not have a high school diploma. Get students thinking about the differences between their answers to (1) and (2). Presenting the Material • Use Handout 19-2 to discuss discrimination. The Supply of Labor Creating Student Interest • Ask students how much income per week (before taxes) they would find satisfactory. (You may want to have them write it on a piece of paper and then collect them.) Determine an average amount that the class seems to find satisfactory. Have students calculate the number of hours per week they would have to work at minimum wage to earn that amount. (Note: As of 2017, the federal minimum wage is $7.25 per hour.) Depending on the satisfactory income level your class has named, there may not be enough hours in the week to earn that amount! Have students calculate how many hours per week they would have to work at $20 per hour or $50 per hour to reach the satisfactory level of income. Based on the calculations, ask students what they would do if they truly felt that level of income was satisfactory and they received a wage increase to much more—say, $100 per hour. (Work fewer hours?) Then ask them if that is what they would choose to do if they actually got a raise to $100 per hour (and why). This discussion will help students understand the income and substitution effects covered in the chapter. Presenting the Material • Discuss labor supply as being derived from an individual’s time allocation problem, where each person has to decide how to allocate the 24 hours available in a day. For simplicity, hours either are spent working or are used for leisure activities. Make sure students understand that leisure includes any activity (even sleep) that is not work. For most people leisure is a normal good. Have students think about the work-leisure trade-off in terms of marginal utility—each individual attempts to balance the marginal utility received from another hour of leisure against the marginal utility received from spending the hourly income on goods and services. Students may at first have difficulty with the idea of choosing work hours if they are already thinking about a 40-hour-a-week salaried job. One option is to have them think about people who work part time, such as students. A second option is to have them think about a person who has more than one job (such as a lower-income person), someone who works a side job on the weekend, or someone who does extra consulting work. • Consider an individual who works 40 hours a week at one job and earns $8 per hour. Suppose that this same individual has a side job on the weekend working 10 hours and earning $8 per hour. What if the individual receives a raise at the 40-hour-a-week job and now makes $10 per hour? Might they quit their extra job? What if the person now makes $12 at the 40-hour-a-week job? Point out to students that this worker will need to evaluate the marginal utility of leisure against the marginal utility gained by having more income to spend on goods and services. Common Student Pitfalls • What is a factor, anyway? A factor of production earns income from selling its services over and over again. An input is used up in the production process. • Getting marginal productivity right. Students often think that the wage of a worker should equal that individual’s marginal product, but that is not what the marginal productivity theory of income says. In equilibrium, wages for all workers in a market will equal the marginal product of the last worker hired. Students may assume that all wages are determined by the marginal productivity of labor in that market. Explain that other factors are involved as well: compensating wage differentials, labor unions, and discrimination, for example. • MP of labor versus value of the MP of labor. Students may not understand the difference between the marginal product of labor and the value of the marginal product of labor. Give a specific example of a baseball pitcher: His MP is how many games he wins; his VMP is how many extra ticket sales he generates from being on the field. • The definition of leisure. Students may think that leisure refers to time relaxing, having fun, or traveling. Explain that in economics the umbrella term leisure includes any activity other than paid work—educational pursuits, time spent with family and in raising children, etc. Students may not understand how the supply of labor curve can be downward sloping. Explain that at a high wage, a lawyer, for example, may have enough income to enjoy more leisure and choose to work fewer hours. The supply of labor curve above that wage will start to bend backward. Chapter Outline Opening Example: The opening example compares the income-earning potential of people with advanced degrees to those with only a high school degree. I. The Economy’s Factors of Production A. A factor of production is any resource that is used by firms to produce a good or service, including physical capital and human capital. B. Factors of production are bought and sold in factor markets. C. Factor prices play a key role in allocating resources among producers. D. Demand for a factor is a derived demand: The demand for the factor is derived from the demand for the firm’s output. II. Marginal Productivity and Factor Demand A. Most factor markets in the modern U.S. economy are perfectly competitive, meaning that buyers and sellers of a given factor are price-takers. B. An employer’s marginal cost of hiring an additional worker is simply the worker’s wage rate. C. The marginal cost of hiring one additional worker must be weighed against the marginal benefit of that additional worker. D. The value of the marginal product of a factor is the value of the additional output generated from hiring one more unit of that factor. E. The formula for the value of the marginal product of labor, assuming perfectly competitive labor markets, is: VMPL = MPL price per unit of output. F. The hiring rule for labor is to hire up until VMPL = W, where W is the wage. G. The hiring rule applies to any factor of production: A profit-maximizing price-taking producer employs each factor of production up to the point at which the value of the marginal product of the last unit of the factor employed is equal to that factor’s price. H. The value of the marginal product curve is equal to the firm’s demand for labor curve. This is illustrated in text Figure 19-3, shown next. I. Shifts in the factor demand curve occur as a result of: 1. Changes in prices of goods: An increase in the price of the good shifts the VMPL curve upward. 2. Changes in supply of other factors: An increase in the supply of a complementary input increases the MPL, shifting the VMPL curve upward. 3. Changes in technology: An improvement in technology that increases MPL shifts the VMPL curve upward. J. The marginal productivity theory of income distribution 1. In perfect competition, the equilibrium wage in the market is equal to the value of the marginal product of labor. 2. The equilibrium value of the marginal product of a factor is the additional value produced by the last unit of that factor employed in the factor market as a whole. K. The markets for land and capital 1. The rental rate of either land or capital is the cost, implicit or explicit, of using a unit of that asset for a given period. 2. According to the marginal productivity theory of income distribution, every factor of production is paid its equilibrium value of the marginal product. III. Is the Marginal Productivity Theory of Income Distribution Really True? A. There are two main objections to the marginal productivity theory of income distribution. 1. In the real world, we see large disparities of income that may not be due to productivity differences. 2. Some people wrongly believe that the marginal productivity theory of income gives a moral justification for the distribution of income. In turn, this sometimes leads people who believe that the current distribution of income is unfair to reject marginal productivity theory. B. Wage disparities in practice 1. There are wage disparities across gender and ethnicity: White males have the highest earnings, while women (averaging across all ethnicities) earn only about 77% as much; African-American workers (male and female combined) earn only 74% as much; and Hispanic workers, only 65% as much. (Data are from text Figure 19-8.) 2. A large part of the observed inequality in wages can be explained by considerations that are consistent with the marginal productivity theory of income distribution. a. Compensating differentials are wage differences across jobs that reflect the fact that some jobs are less pleasant than others. Dangerous and hazardous jobs pay more. b. Individuals differ in talent and abilities. c. Individuals differ in the amount of human capital they have. 3. Marginal productivity theory does not explain all the inequality in wages. There are three major additional explanations. a. Market power (1) Factor markets are not perfectly competitive. (2) Definition: Unions are organizations of workers that try to raise wages and improve working conditions for their members by bargaining collectively with employers. b. Efficiency wages (1) Employers pay wages above VMPL to increase worker effort and decrease turnover. c. Discrimination: Although market forces tend to work against discrimination, employers may have the ability to discriminate without hurting their profits when labor markets don’t work well. IV. The Supply of Labor A. Work versus leisure 1. In the labor market, labor is demanded by firms and supplied by households. 2. Decisions about labor supply result from decisions about time allocation, how many hours to spend on different activities. Individuals choose between work and leisure activities. 3. Leisure is time available for purposes other than earning money to buy goods. This includes spending time with family or pursuing hobbies. 4. The opportunity cost of leisure is the forgone income that could have been earned. 5. The opportunity cost of work is the forgone leisure activities that could have been engaged in. 6. Individuals decide on how much leisure to consume by making a marginal comparison: They compare the marginal utility of an additional hour of leisure with the marginal utility they get from the income earned from an additional hour of work. 7. The optimal labor supply choice occurs when the marginal utility of one hour of leisure is equal to the marginal utility one gets from the goods that one’s hourly wage can purchase. B. Wages and labor supply 1. If an individual chooses to work more hours as a result of a wage increase, the substitution effect dominates. This is shown graphically as an upward-sloping labor supply curve. 2. If an individual chooses to work fewer hours as a result of a wage increase, the income effect dominates. This is shown graphically as a downward-sloping labor supply curve. 3. Americans’ increasing consumption of leisure over the past century indicates the income effect is stronger than the substitution effect. C. Shifts in the labor supply curve 1. The labor supply curve can shift due to: a. changes in preferences and social norms. b. changes in population. c. changes in opportunities for workers. d. changes in wealth; an increase in wealth can increase the ability to consume more leisure and shift the labor supply curve to the left. Teaching Tips Case Studies in the Text Economics in Action The Factor Distribution of Income in the United States—This EIA presents the factor distribution of income in the United States in 2013. Ask students the following questions: 1. Why don’t wages measure the full return to labor? (Labor also receives compensation in the form of health insurance. In addition, a large number of people own their own businesses and earn sole proprietor income.) 2. Why is human capital the most important factor of production in a modern economy? (Human capital is a measure of a worker’s education and training. Workers who are more skilled and educated earn higher wages.) Help Wanted at Flex!—This EIA uses a manufacturing firm in Pennsylvania to illustrate the relationship between the value of marginal product for labor and wages. The EIA shows that the marginal productivity theory holds in this case. Ask students the following questions: 1. What is the average annual revenue generated by a machinist? What is the average salary of a senior machinist? ($137,000/$70,000.) 2. What explains the gap between revenues generated by and salaries paid to machinists at Hamill Manufacturing? Does it mean that the marginal productivity theory does not hold? (The marginal productivity theory does hold. Workers are paid the value of the marginal product of the LAST worker hired and not the average worker. In addition, the wage must include the benefits provided to workers, as well as other costs associated with hiring the worker.) Marginal Productivity and the “1%”—This EIA discusses rising income inequality by examining the change in household income from 1979–2015. Ask students the following questions: 1. By what percentage did household income change for workers with a high school degree as compared with an advanced degree? (–2.5% and 25%.) 2. Why do the data suggest that the large increase in the household income of the 1% is not due to those households having more education? (The gains to workers with advanced degrees as a whole is only a fraction of the gains to the 1% [27.5% versus 228.8%].) The Decline of the Summer Job—This EIA presents data showing the number of young Americans taking summer jobs is declining. Reasons cited include: increased emphasis on summer study, increased affluence of American households, and competition for jobs from immigrants. Ask students the following questions: 1. In what way did the income effect cause a decline in the number of teenagers willing to work in the summer? (The increase in household wealth over the last 20 years means families can afford to have their teenagers not working in the summer.) 2. How did the 2007–2009 recession contribute to the decline in teenage employment in the summer? (Firms and governments hired fewer teens in an attempt to reduce cost, and there was more competition from older workers who were unemployed.) For Inquiring Minds The Factor Distribution of Income and Social Change in the Industrial Revolution—This FIM discusses the shift of factor income from land to capital in England as a result of the industrial revolution. How Labor Works the German Way—This FIM explains why blue collar workers in the manufacturing sector in Germany are so well paid. Why Can’t You Find a Cab When It’s Raining?—This FIM uses the income and substitution effect to explain why cab drivers go home early on rainy days (when they are able to earn a higher wage due to increased demand for cabs). Global Comparison The Overworked American?—Average annual hours worked in eight Western countries are presented. The data show that U.S. workers work the most hours. Government policies in other countries contribute to the lower average hours worked. Business Case Walmart Gives a Hike—This business case discusses a commitment by Walmart to pay employees higher wages and to provide better training. Web Resources For information about the relationship between the level of education and wages, search “education level and income data.” Some notable links are https://www.bls.gov/, https://www.collegeboard.org/, and https://www.census.gov/. The Department of Labor provides average wages for 400 occupations at https://www.bls.gov/ (click on Data Tools, then Pay and Benefits, then National Compensation Survey, then Tables). These websites offer information about the gender pay gap across different states and across countries: http://www.aauw.org/resource/gender-pay-gap-by-state-and-congressional-district/ https://www.weforum.org/reports/the-global-gender-gap-report-2016 Handout 19-1 Date _________ Name ___________________ Class ________ Professor ________________ In the following table calculate the marginal product of labor and the value of marginal product, given a product price of $5. • Quantity of labor • Quantity of widgets • Marginal product of labor (ΔQ/ΔL) • Value of the marginal product (marginal product × product price) • 0 • 0 • — • — • 1 • 38 • • • 2 • 72 • • • 3 • 102 • • • 4 • 128 • • • 5 • 150 • • • 6 • 168 • • • 7 • 182 • • • 8 • 192 • • 1. If the equilibrium wage rate is $100, how many workers will the firm hire? 2. If the equilibrium wage rate is $80, how many workers will the firm hire? 3. If the equilibrium wage rate is $60, how many workers will the firm hire? Answers • Quantity of labor • Quantity of widgets • Marginal product of labor (ΔQ/ΔL) • Value of the marginal product (marginal product × product price) • 0 • 0 • — • — • 1 • 38 • • • 2 • 72 • • • 3 • 102 • • • 4 • 128 • • • 5 • 150 • • • 6 • 168 • • • 7 • 182 • • • 8 • 192 • • 1. If the equilibrium wage rate is $100, how many workers will the firm hire? The firm will hire 5 workers. 2. If the equilibrium wage rate is $80, how many workers will the firm hire? The firm will hire 6 workers. 3. If the equilibrium wage rate is $60, how many workers will the firm hire? The firm will hire 7 workers. Handout 19-2 Date _________ Name _____________________ Class ________ Professor ________________ Discrimination? Figure 19-8 in the book indicates that women earn $0.77 for every $1 earned by a man. Which of the explanations below are about differences in VMPL between men and women? How could you explain the wage disparity with these explanations? • Compensating wage differentials • Choice of college major and choice of career • Time constraints • The differing negotiating skills of men and women • Number of years of experience • Number of years in continuous employment • Number of hours of work • Employer discrimination • Customer discrimination Answers • Compensating wage differentials Men may be employed in more dangerous or “dirty” jobs that pay more. • Choice of college major and choice of career Women may choose “service” majors, like teaching and nursing, rather than leadership majors, like business or pre-medicine. • Time constraints Mothers may have only limited time to pursue career advancement or may take time off to raise their families. • The differing negotiating skills of men and women Men may be more assertive. • Number of years of experience Women who take time out of the labor force to raise their families have less experience. • Number of years in continuous employment Women who take time out of the labor force to raise their families have less continuous employment. • Number of hours of work Women who have children may be constrained by school and daycare hours. • Employer discrimination Women may be discriminated against as employers may prefer to hire males. • Customer discrimination Customers may prefer working with males. Chapter 20: Uncertainty, Risk, and Private Information What’s New in the Fifth Edition? • Updated business cases Chapter Objectives • Discuss risk and risk aversion as key features of the economy. • Explain why diminishing marginal utility makes people risk averse. • Determine the premium people are willing to pay to reduce risk. • Explain how risk-averse individuals can pay others to assume part of their risk. • Explain how exposure to risk can be reduced through diversification and pooling. • Define the special problems posed by private information, where some people know things that others do not. Teaching Tips The Economics of Risk Aversion Creating Student Interest • Ask students to classify their overall tolerance for risk, using a scale of 1 to 10, with risk-loving being a 10 and risk-averse being a 1. Now ask them what types of risky behavior they engage in. Even risk-averse people will engage in some types of risky behavior. • Discuss with the class why, if most people are risk-averse, they gamble. • Ask students who they think are more risk-averse: poor people or rich people. • Are students equally willing to “risk” not completing a reading assignment when there could be a quiz covering the readings during the next class? What factors can affect students’ willingness to accept this kind of risk? How might risk aversion in this situation contribute to success in the class? Presenting the Material • Tell students that the expected-value formula can be applied to expected income and expected utility in the face of uncertainty. EV = (P1 × S1) + (P2 × S2) + … + (PN × SN) • Use Handout 20-1 to have students work with expected income and expected utility. Buying, Selling, and Reducing Risk Creating Student Interest • Ask students to give examples of ways that they minimize their own risks. Do they buy insurance for their cars, belongings, or health care? Do they use bike or car locks or other antitheft devices? Do they always complete reading and other assignments in case the contents are on an exam? • Ask students why they think people invest in mutual funds rather than individual company stocks. What about the wisdom/risk of investing only in your own company’s stock (as many Enron employees did before Enron’s collapse)? Presenting the Material • Students need help clarifying the demand and supply graph for insurance. The demand for insurance is the willingness of buyers of insurance to pay for the coverage. The supply of insurance premiums represents the willingness of insurers to take on the risk at various prices. The equilibrium premium is where the quantity demanded for insurance equals the quantity supplied by insurers. Use text Figure 20-5, shown here, to illustrate the insurance market. • Use the text examples of how diversification can reduce risk. An individual or firm can invest in several different things so that the possible losses are independent events—two events are independent events if each of them is neither more nor less likely to happen if the other one happens. Private Information: What You Don’t Know Can Hurt You Creating Student Interest • Ask students about their experiences buying a used car. How did they attempt to find out more about the condition of the car? • Have students explain why insurance companies insist on deductibles in their insurance policies. • Present the example of automobile safety devices increasing risky behavior. How might you drive differently when you know you have a seat belt and airbag—rather than a sharp spike sticking out from the middle of your steering wheel? The spike would give drivers a greater incentive to drive carefully! Presenting the Material • Help students walk through the logic of adverse selection in the used-car market: ○ Buyers do not have complete information about a used car. ○ Buyers are suspicious of the quality of cars in the used-car market. ○ Buyers offer lower price bids for used cars. ○ Used cars now command lower prices. ○ Sellers of higher-quality cars are reluctant to bring them to the market because of the lower price of used cars. ○ Only poorer quality cars are offered for sale. • In the case of moral hazard, one person has more information about his or her behavior than others do. Give the following examples: fire insurance, shirking at work, and fast-food franchises as a way to ensure quality management behavior. Common Student Pitfalls • Before the fact versus after the fact. In uncertain situations, decisions must be made using the information available before the fact. The rationality of the decision must be evaluated without knowing how the situation will turn out. Once the outcome is determined (after the fact), the situation is no longer uncertain. Is the decision to buy or not buy flood insurance rational? After a flood, the decision to buy insurance obviously seems to have been rational and the decision not to buy insurance may seem irrational. However, the decision to buy the insurance or not has to be made before knowing if a flood will happen—based on “before-the-fact” information. Rationality of a decision must be determined based on before-the-fact information. • The difference between utility and expected utility. From prior chapters, students are familiar with the idea of maximizing total utility. Now they need to understand that, given uncertainty, people instead attempt to maximize expected utility. Chapter Outline Opening Example: The opening story identifies extreme weather events that occurred during 2016 that were especially costly. These events included 15 major storms spawning seven hurricanes, high temperatures and drought, tornadoes, and hail storms. The example discusses the financial risk of weather events and market responses to the risk. I. The Economics of Risk Aversion A. Expectations and uncertainty 1. In general, people do not like risk and are willing to pay a price to avoid it. 2. Risk is uncertainty about future outcomes. When the uncertainty is about monetary outcomes, it becomes financial risk. B. The logic of risk aversion 1. Diminishing marginal utility gives rise to risk aversion. 2. A premium is a payment to an insurance company in return for the insurance company’s promise to pay a claim in certain states of the world. 3. A fair insurance policy is an insurance policy for which the premium is equal to the expected value of the claim. 4. Risk-averse individuals will choose to reduce the risk they face when that reduction leaves the expected value of their income or wealth unchanged. Text Table 20-1, shown next, gives an example of this. TABLE 20-1 The Effect of Fair Insurance on the Lee Family’s Income Available for Consumption and Expected Utility • • Income in different states of the world • Income in difference states of the world • • • • $0 in medical expenses (0.5 probability) • $10,000 in medical expenses (0.5 probability) • Expected value of income available for consumption • Expected utility • • Without insurance • $30,000 • $20,000 • (0.5 × $30,000) + (0.5 × $20,000) = $25,000 • (0.5 × 1,080 utils) + (0.5 × 920 utils) = 1,000 utils • With fair insurance • $25,000 • $25,000 • (0.5 × $25,000) + (0.5 × $25,000) = $25,000 • (0.5 × 1,025 utils) + (0.5 × 1,025 utils) = 1,025 utils 5. The purchase of a fair insurance policy increases expected utility because with diminishing marginal utility, a dollar gained when income is low adds more to utility than a dollar lost when income is high. 6. Almost everyone is risk-averse because almost everyone has diminishing marginal utility. 7. Individuals differ in risk aversion for two main reasons: differences in preferences and differences in initial income or wealth. (People with high incomes or wealth will be less risk-averse.) 8. A risk-neutral person is completely insensitive to risk. C. Paying to avoid risk 1. Risk-averse individuals are willing to make deals that reduce their expected income but also reduce their risk: They are willing to pay a premium that exceeds their expected claim. 2. The more risk-averse people are, the higher the premium they are willing to pay to reduce risk. II. Buying, Selling, and Reducing Risk A. Trading risk 1. The market economy as a whole “trades” and thereby transforms risk. 2. The insurance industry rests on two principles: a. Trade in risk, like trade in any good or service, can produce mutual gains. b. Some risk can be made to disappear through diversification. 3. Trading risk: People often trade away things they do not like to other people who dislike them less. 4. An efficient allocation of risk is an allocation of risk in which those who are most willing to bear risk are those who end up bearing it. 5 The trading of risk between individuals who differ in their degree of risk aversion plays an extremely important role in the economy. This is illustrated in text Figure 20-5, shown next. 6. In a market with many buyers and sellers of insurance, the supply and demand curves will take on their normal smooth shape and the market will move toward equilibrium. B. Making risk disappear: The power of diversification 1. Diversification makes some risk disappear. 2. Diversification is made easier in a modern economy when investors can easily buy shares in many companies by using the stock market. 3. Insurance companies engage in pooling of risks. C. The limits of diversification 1. There are limits to diversification. 2. Many financial risks are positively correlated and so cannot be diversified away. 3. Positively correlated financial risks include severe weather, political events, and business cycles. 4. There is an irreducible core of risk that cannot be diversified. 5. Markets for risk, however, accomplish two things: They enable the economy to eliminate the risk that can be diversified, and they allocate the risk that remains to the people most willing to bear it. III. Private Information: What You Don’t Know Can Hurt You A. Adverse selection: The economics of lemons 1. Private information is information that some people have that others do not; also called asymmetric information. 2. Markets can have trouble with situations of private information because such information can distort economic decisions and sometimes prevent mutually beneficial economic transactions from taking place. 3. Adverse selection occurs when an individual knows more about the way things are than other people do. The existence of private information leads buyers to expect hidden problems in items offered for sale, leading to low prices and the best items being kept off the market. 4. Adverse selection is a problem for many parts of the economy, especially the insurance industry. 5. Adverse selection can be reduced through screening or by people signaling their private information through actions that credibly reveal what they know. B. Moral hazard 1. Moral hazard occurs when an individual knows more about his or her own actions than other people do. This leads to a distortion of the incentive to either take care or to exert effort when someone else bears the costs of not taking care or not putting in the effort. 2. To deal with moral hazard, individuals with private information must be given some personal stake in what happens. 3. Insurance companies deal with moral hazard by requiring a deductible. 4. Moral hazard limits the ability of investors to diversify their investments. Case Studies in the Text Economics in Action Warranties—This EIA discusses some of the reasons why manufacturers offer warranties. Ask students the following questions: 1. Why do manufacturers offer warranties? (The warranty is a signal of high quality and is a form of consumer insurance.) 2. Why do consumers want a warranty? (It increases the expected utility.) 3. What happens to the consumer’s total utility and marginal utility of income if he or she has to pay for the cost of repair of the item purchased? (Assuming no utility is gained from having the item repaired, total utility would be reduced. However, because the cost of repair reduces the amount of money available for the consumption of other goods, the marginal utility of income is higher than it would be if the consumer did not have to pay for a repair.) When Lloyd’s Almost Lost It—This EIA explains how Lloyd’s took on high levels of risk by insuring against events that were not independent. By insuring many U.S. corporations against liability, Lloyd’s ended up paying for claims against the insured companies for health problems caused by asbestos. Ask students the following questions: 1. What type of insurance caused Lloyd’s financial problems? (Corporate liability insurance.) 2. What had Lloyd’s investors assumed about the risk of this type of insurance? (They assumed that one company’s legal problems would be unrelated to another firm’s legal problems.) 3. What happened to cause Lloyd’s to lose money? (The suits from asbestos poisoning were economy-wide, so that all firms were affected. These cases were no longer independent events.) Franchise Owners Try Harder—This EIA explains how there is a moral hazard problem with franchise stores run by salaried managers. Franchise owners work harder to ensure their own success along with the success of their store. Ask students the following questions: 1. Why do fast-food companies prefer franchises to hiring a manager who works for the company? (They do not know whether a manager will shirk; this is a case of moral hazard that can be remedied by giving the franchisees a personal stake in the profits.) 2. Why is this story a case of moral hazard? (Managers will know more about their efforts than the company will.) For Inquiring Minds The Paradox of Gambling—This FIM discusses why, even though most people are risk-averse, so many people gamble in Las Vegas. The answer can be found in the enjoyment that is part of the gambling experience. Those Pesky Emotions—Financial economists suggest that small investors should buy index funds. Yet most small investors buy individual stocks or other types of funds. Why do these investors not follow experts’ advice? This FIM explains how emotions can figure into investment decisions. Business Case PURE—An Insurance Company That Withstands Hurricanes—This business case discusses how PURE insures in Florida. Web Resources Find “Anomalies: Risk Aversion” by Rabin and Thaler at http://faculty.chicagobooth.edu/richard.thaler/research/pdf/JEPV15N1.pdf. This article from the Journal of Economic Perspectives explains the role of risk aversion in economic models. Handout 20-1 Date _________ Name _______________________ Class ________ Professor ________________ Karen has a 60% chance of earning $22,000 or a 40% chance of earning $35,000. The utility that results from various income levels is: • Income • Total utility • $22,000 • 850 • 25,000 • 1,014 • 26,000 • 1,056 • 35,000 • 1,260 1. What is Karen’s expected income? 2. What is Karen’s expected utility? 3. Will Karen be willing to pay for insurance to guarantee income? If so, how much must her income be to be willing to pay? Answers 1. What is Karen’s expected income? The expected income is: (0.60 × $22,000) + (0.40 × $35,000) = $27,200 2. What is Karen’s expected utility? The expected utility is: (0.60 × 850) + (0.40 × 1,260) = 1,014 3. Will Karen be willing to pay for insurance to guarantee income? If so, how much must her income be to be willing to pay? In this case, at the income levels of $26,000 and $35,000, Karen would be willing to pay for insurance to guarantee income because the utility from certainty is greater than the utility that will result from uncertainty. It is not worth it to insure an income of $22,000 because the expected utility from uncertainty is greater than the expected utility of certainty. Handout 20-2 Date _________ Name _____________________ Class ________ Professor ________________ Adverse Selection or Moral Hazard (10–15 minutes) Classify each of the following scenarios as an example of adverse selection or moral hazard. 1. Nordstrom’s cannot predict who is going to be a good shoe salesperson. 2. A health insurance policy that has no deductibles and unlimited use of chiropractic visits is used to the maximum allowed by some patients. 3. Poor drivers seek out car insurance more than good drivers do. 4. Airline companies offer an expensive ticket that allows you to fly immediately and a lower-priced ticket with more flexible use. 5. CEOs shirk and do not maximize the company’s profits. Which strategy from the following list would remedy the problem in each of these cases? 1. Screening 2. Signaling 3. Establishing a reputation 4. Deductibles 5. Requiring a person to have a personal stake in the outcome Answers 1. Nordstrom’s cannot predict who is going to be a good shoe salesperson. Moral hazard. Salespeople know more about their performance on the job than Nordstrom’s may know. Requiring a person to have a personal stake in the outcome could remedy the problem. 2. A health insurance policy that has no deductibles and unlimited use of chiropractic visits is used to the maximum allowed by some patients. Moral hazard. Individuals know how sick they really are and if they really need all of the treatments. This is also an example of adverse selection. People with bad backs will be the most likely to take advantage of the policy. Add deductibles to the policy. 3. Poor drivers seek out car insurance more than good drivers do. Adverse selection. Poor drivers know their driving habits but insurance companies do not; the company winds up with more poor drivers as their customers. Screening may help. 4. Airline companies offer an expensive ticket that allows you to fly immediately and a lower-priced ticket with more flexible use. Moral hazard. Business travelers know they need to travel tomorrow but the airline company does not. Screening may remedy the problem 5. CEOs shirk and do not maximize the company’s profits. Moral hazard. CEOs know their own behavior but the stockholders do not. Requiring a CEO to have a personal stake in the outcome would improve behavior. Instructor Manual for Microeconomics Paul Krugman, Robin Wells 9781319098780
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