Page 844 - Krugmans Economics for AP Text Book_Neat

Section 14 Appendix Review

Summary
1. Private information can cause inefficiency in the allo- the slope of the indifference curve when R is on the hor-
cation of risk. One problem is adverse selection, the re- izontal axis and M is on the vertical axis. Convex indif-
sult of private information about the way things are. It ference curves get flatter as you move to the right along
creates the “lemons problem” in the used-car market be- the horizontal axis and steeper as you move upward
cause buyers will pay only a price that reflects the risk of along the vertical axis because of diminishing marginal
purchasing a lemon (bad car), which encourages sellers utility: a consumer requires more and more units of R to
of high-quality cars to drop out of the market. Adverse substitute for a forgone unit of M as the amount of R
selection can be limited in several ways—through the consumed rises relative to the amount of M consumed.
screening of individuals, through signaling that peo- 5. Most goods are ordinary goods, goods for which a
ple use to reveal their private information, and through consumer requires additional units of some other
the building of a reputation. good as compensation for giving up some of the good,
2. A related problem is moral hazard: individuals have and for which there is a diminishing marginal rate
private information about their actions, which distorts of substitution.
their incentives to exert effort or care when someone 6. A consumer maximizes utility by moving to the high-
else bears the costs of that lack of effort or care. It limits est indifference curve his or her budget constraint al-
the ability of markets to allocate risk efficiently. Insur- lows. Using the tangency condition, the consumer
ance companies try to limit moral hazard by imposing chooses the bundle at which the indifference curve
deductibles, placing more risk on the insured. just touches the budget line. At this point, the relative
3. Preferences can be represented by an indifference price of R in terms of M, P R /P M (which is equal to the
curve map, a series of indifference curves. Each curve negative of the slope of the budget line when R is on
shows all of the consumption bundles that yield a given the horizontal axis and M is on the vertical axis) is
level of total utility. Indifference curves have two gen- equal to the marginal rate of substitution of R in place
eral properties: they never cross and greater distance of M, MU R /MU M (which is equal to the negative of the
from the origin indicates higher total utility levels. The slope of the indifference curve). This gives us the rela-
indifference curves of ordinary goods have two addi- tive price rule: at the optimal consumption bundle,
tional properties: they slope downward and are convex the relative price is equal to the marginal rate of sub-
in shape. stitution. Rearranging this equation also gives us the
4. The marginal rate of substitution, or MRS, of some optimal consumption rule. Two consumers faced with
good R in place of some good M—the rate at which a the same prices and income, but with different prefer-
consumer is willing to substitute more R for less M—is ences and so different indifference curve maps, will
equal to MU R /MU M and is also equal to the negative of make different consumption choices.

Key Terms

Private information, p. 782 Moral hazard, p. 785 Diminishing marginal rate of substitution, p. 795
Adverse selection, p. 783 Deductible, p. 785 Ordinary goods, p. 795
Screening, p. 783 Indifference curve, p. 789 Tangency condition, p. 796
Signaling, p. 784 Indifference curve map, p. 789 Relative price, p. 797
Reputation, p. 784 Marginal rate of substitution (MRS), p. 794 Relative price rule, p. 798

802 section 14 Market Failure and the Role of Gover nment