GET1023 – Thinking Like an Economist

Semester 1, 2016

Matriculation number: __________________________

Midterm

Instructions

Please answer all the questions on this question sheet. You have 70 minutes to finish this exam.
Please explain your answers as fully as possible. Credit will be given based largely on your
explanations. If you need any clarifications, please raise your hand and ask a question out loud;
so loud that all the people in the room can hear the question and the answer.

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1. “Altruistic behavior presents a challenge to rationality.” Discuss this statement. (5 points)

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If we want to be accurate altruistic behavior does not present a challenge to rationality
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per se. Altruistic behavior presents a challenge to the most common way in which
rationality is manifested, that is selfish behavior. Rational behavior is not necessarily
selfish. Rational behavior is defined as a behavior by which people rank order their
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preferences and then choose the most desired feasible choice. However, rationality has
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nothing to say about the preferences themselves, which can be altruistic, or self-
destructive, or whatever. Because most of the time rational behavior is associated with
selfish preferences, one might think that widespread altruistic behavior contradicts
rational behavior. However, this is not true. Altruism just runs contrary to the most
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common manifestation of rationality but does not contradict rationality itself.

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Moreover, research has shown that, on several occasions, what we observe as altruistic
behavior turns out to have selfish motivation. The classic example is “warm glow”
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altruism whereby people behave altruistically in order to feel better about themselves.
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Other even more selfish motivations are frequently observed as well, such as obtaining
tax credits, boosting public image (think of actors), etc.

So the bottom line is that we observe as altruism may actually be selfishness in disguise.
But even if it is true altruism, still this would pose no problem for rationality, as
rationality allows for non-selfish preferences. It allows for any type of preferences for
that matter.

[The major point of this answer was the first paragraph. Many people answered based on
the second paragraph which was more of a minor point. Full credit was given if both
points were addressed.]

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 2. According to John Rawls’s A Theory of Justice:

(a) How do the people in the original position, using the maximin rule, end up
choosing a distribution that ensures “equal basic liberties for all… and equal
division of income and wealth”? Explain and provide a numerical example. (7
points)
(b) How is the “difference principle” consistent with Pareto efficiency? (3 points)
(c) How does Rawls defend the difference principle against arguments that the
enrichment of the better by large amounts turns on whether the prospects of the
least favored increase or decrease by a penny? (2 points)

(a) We know that behind a veil of ignorance, people will choose a distribution
whereby “each person is to have an equal right to the most extensive scheme of

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equal basic liberties.” We also know that this is the result of an application of the

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maximin rule, according to which a risk averse person will choose a distribution

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which will give the most to the least favored person, out of fear that this least

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favored person will be him or her. A consistent application of the maximin rule

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when all possible distributions of a resource are available (and we have no reason
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to believe that they are not when people are making their choices behind the veil
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of ignorance) will eventually lead all people to choose an equal distribution of the
resource.
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For example, assume that we have two people that want to split a resource which
has 4 equal parts. We have the following possible distributions: (0,4), (1,3), (2,2).
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The two people choosing behind a veil of ignorance and applying the maximin
rule will naturally choose a (2,2) distribution, as this distribution gives the most to
the least favored person.
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We observe that the maximin rule is a nice way of justifying and rationalizing an
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equal, initial distribution of resources.

[Most people got this right or almost right.]

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(b) We know that the difference principle allows inequalities to exist (after the initial
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equal distribution of resources) only if the extra wealth generated trickles down to
the poorer members of society. So one can get rich, if the poor get a (small) chunk
out of this extra wealth as well. This is consistent with Pareto efficiency because
we know that Pareto efficiency would never allow moving to another distribution
if one person is hurt. Therefore the difference principle does not contradict the
Pareto efficiency criterion.

[Most people got this right or almost right.]

(c) Rawls responds to this criticism by making an assumption, saying that such a
situation cannot arise in real cases. The reason is that the operation of the two
principles of justice (equal liberty and the difference principle) would tend to

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 shrink the potential for inequalities by increasing the availability of educated
talent and by widening opportunities for the most disadvantaged people. It is thus
argued that the inequalities arising under his system, even though they might be
significant, will be much less pronounced than people have tolerated in the past.

[Very few people got this right.]

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 3. What is the difference between the minimal and the ultraminimal state according to
Nozick? (3 points)

The difference between the minimal and the ultraminimal state is that the minimal state
compensates the independents by providing them free protection in the disputes they
might have with paying members of the dominant protective association. This is done out
of moral obligation because the dominant protective association has deprived the
independents of their right to protect themselves (self-help) against its clients. In contrast,
the ultraminimal state does not provide that free protection. The transition from
ultraminimal to minimal state will occur because we assume people will do what they are
morally required to do.

[The key points were “Free protection”, “moral obligation” and “deprived of right to self-

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help”. Very few got this fully right.]

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4. In a country with a very unequal distribution of wealth, a new social-democratic

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government has been elected and wants to achieve a more equal distribution of wealth.
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Using the concepts presented in this class, what would you advise this government to do
in order to achieve its goal? (4 points)

According to the Second Fundamental Theorem of Welfare Economics, if a society

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doesn’t like the current distribution of wealth, all it needs to do is redistribute the
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resources among its citizens and then let the competitive markets take over and lead it to
a new Pareto efficient distribution that will be more in line with the desired distribution.
Therefore, since the new government wants to achieve a more equal wealth distribution,
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we would advise it to redistribute wealth in a more equal way right now and then let the
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markets take over and lead society to a new more equal Pareto efficient distribution.

[If only taxes were mentioned, partial credit was given. A full answer incorporates the 2nd
fundamental theorem.]

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 5. Please allow me to introduce the ice-cream company “Gelatomaniac Inc.” Every year the
company gets sued at least 100 times by customers who claim that its ice cream is too
cold and it caused damage to their teeth (assume that scientific evidence says that this is
extremely unlikely to be true).

(a) In general, how are managers of companies inclined to respond to this kind of
litigious behavior on the part of consumers? Describe thoroughly what explains
their responses. (7 points)
(b) Is there any better way to deal with such lawsuits? Provide a numerical example
to justify your answer. (4 points)

(a) This is a case of frivolous lawsuits filed against a company. We are told that the
claim is extremely hard to be substantiated so we assume that probability of the

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company losing the case is small.

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However, the manager perceives this probability as higher that what it really is

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due to the possibility effect in the case of losses. Assume that the probability of
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losing the case is 5%. However, in the head of the manager this 5% will loom
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larger, urging her to settle out of court, offering to the customer an unfavorable
deal for the company. This is equivalent to buying insurance for the unlikely
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event of losing the case in court.

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An equivalent way to view this problem is by saying that the manager is subject
to the certainty effect in the case of gains. Suppose that the probability of winning
is 95% but the manager perceives that as lower than it really is. She is thus led to
offer to the customer an unfavorable settlement for her company.
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Either way we view it, a risk averse manager will be inclined to settle for an
amount that is higher than the objective probability would justify.
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[Citing only the possibility or certainty effect will earn partial credit. Some people
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gave the customers’ point of view but this was not relevant. Most were able to get
at least half or full credit.)

(b) A better way to deal with such lawsuits is to just take all of them to court. That
way on average the company will pay less than if it offers all these unfavorable
settlements. Suppose the claim is for $100, there are 100 cases and the probability
of the company losing is 5%. Then if the company litigates all the cases, it will
lose 5 times and pay in total $500 (5 cases lost × $100 per case). But if it settles
each case, for say $10, then it will end up paying $1000 ($10 per case × 100 cases
settled). So it’s better if the company litigates all the cases.

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 [Any logical numerical answer earns full credit. Most people were able to get at
least half or full credit.]

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