MICROECONOMICS – PROBLEM SET 7

Choice under uncertainty

Asymmetric information
Externalities

Textbook references for the topics covered in this problem set are:
- Bernheim and Winston, Microeconomics, Chapters 11, 20 and 21
- Microeconomics- Exercises Chapters 9, 10 and 11

This problem set consists of 2 sections:

First section – True or false;
Second section - Exercises.

First Section – True or false

1) A risk-averse individual will never buy a lottery ticket, even if the ticket price is less than
the expected winnings.

2) Consider the following lotteries. The first lottery (L1) gives 2€ with probability 0.5 and 4€
with probability 0.5. The second lottery (L2) gives 6€ with probability 0.5, nothing otherwise.
A risk-loving individual will prefer to take part in the second lottery rather than in the first
one.

3) There are two types of individuals: high-skill and low-skill. Due to asymmetric infor-
mation firms cannot distinguish between the two types. Getting a diploma costs a high-ability
individual €5,000 while it costs a low-ability individual €8,000. If firms offer a salary of
€10,000 to workers without a diploma and of €17,000 to those with a diploma, then only
high-ability individuals will obtain a diploma.

4) A factory dumps its by-products into a nearby river thus polluting the body of water and
generating a negative externality on fishermen. The more output produced, the more by-
product is produced and thus the more pollution that goes into the river. The optimal policy is
a tax on the factory such that production (and therefore pollution) is equal to 0.

5) In the presence of a negative externality, a monopolist can produce the socially optimal
level of output.

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 Second Section – Exercises

Exercise 1

John’s only wealth is a diamond of value 16. Unfortunately, there is a risk that this diamond
might get stolen (in which case he is left with no wealth at all). The probability of a theft is
¼. John’s utility function is .

a) Calculate the expected value of John’s wealth.

b) Calculate John’s expected utility and certainty equivalent. Is the latter smaller or larger
than the certainty equivalent? Explain!

c) The risk neutral insurance company AGSA offers John the following insurance contract:
John pays an insurance premium of 4. In exchange AGSA promises to fully reimburse John
in case his diamond gets stolen. Would John be willing to take out the insurance? Why?

d) John’s friend Bill offers to buy John’s diamond (doing so means that now Bill is the one
who will face the risk that the diamond is stolen with probability ¼) at the price of 13. What
does this tell us about Bill’s risk attitude?

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Exercise 2

Each entry-level software programmer has either high or low ability. All potential employers
value a high-ability worker at € 190 and a low-ability worker at € 130. The supply of high-
ability workers is , while the supply of low-ability workers is
, where is the wage.

a) If workers’ abilities are observable to employers, what are the equilibrium wages?

b) How many workers of each type do employers hire? Represent the equilibrium in a graph.

c) If workers’ abilities are not observed by employers, what are the equilibrium wages? How
many workers of each type do employers hire in this case?

d) What is the deadweight loss due to asymmetric information?

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Exercise 3

Shareholders (the Principal) hire a manager (the Agent) to run a business on their behalf. The
principal wants to maximise profits, which depend on output ( ) and labour cost ( ) accord-
ing to the following relationship: . The agent wishes to maximise his utility,
, which is increasing in his pay ( ) and decreasing in the level of effort ( )
undertaken during the working activity, with .
The manager’s effort affects the probability of running a successful business as reported in
the table below. Moreover, we assume that the manager has a reservation utility equal to . In
other words, if the manager were to turn down the contract proposed by the shareholders, his
alternative best opportunity would give him a total utility .

Output
Effort
probability probability
probability probability

(1) Write down the agent’s participation constraint when the effort exerted during working
activity is and when it is . What is the minimum wage necessary in each case to
convince the manager to take the contract?

(2) Suppose that shareholders can monitor the level of effort undertaken by the manager.
Identify the contract that would be offered to the agent and the expected profits of the princi-
pal.

(3) Now the principal cannot monitor the level of effort undertaken by the agent. What incen-
tive system could induce a high level of effort?

(4) May the incentive system at point (3) enable shareholders to replicate the first-best out-
come (i.e. the outcome with complete information)? Motivate your answer.

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Exercise 4

A steel firm operates with a cost function C (q ) = q 2 + 50q where q is the output. The firm
operates in a competitive industry and the price of the good is 150. The firm exerts a negative
externality to fishermen equal to 20 for every unit of output produced.

a) Find the firm marginal cost and the social marginal cost

b) What is the output that maximizes firm profit? What is the level of profit for the firm?

c) Find the social optimal level of output.

d) Suppose a Pigouvian tax t is levied on the firm. What is the value of t? Compute the firm’s
profit when the Pigouvian tax is applied.