From the Perfect to the Imperfect
Problems, Exercises, Essay Questions


1. Devise a simple economy in class, with only two products, two factors of production, two citizens, but not money (it's a pure barter economy). Discuss the general equilibrium of this economy. What happens if there is unexpectedly an increase in the supply of one of the factors, say it is labor. Talk through as many of the direct and indirect features as you can.

2. Look around campus and spot three externalities of what people do.

3. Give some examples of information provided to you free by markets.

4. You are hiring a night guard for a warehouse filled with valuable electronic equipment. Suppose night guards seldom give up their jobs voluntarily. You need an experienced person. Describe the lemons problem you face.


5. Describe the loss of "efficiency" if a ticket to the basketball game does not end up in the hands of the person who values it the most. What's the dollar measure of the lost efficiency? Use the argument to make a case for "scalping," that is, allowing people to resell basketball tickets. Describe it in terms of making one person better off without making anyone else worse off.

6. Rodney says, "It's better that government owns the corporations than the rich people." Thinking efficiency, use the analogy with the public lands to address the argument.

7. What's the high transaction cost in dealing with pollution from factories? Take the case of smog in the Appalachian Mountains caused by smoke stacks hundreds of miles away. Identify exactly who the people are who own the property or are affected by the pollution. Why doesn't the market work?

8. Explain exactly why you cannot solve an externality problem by simply taxing the "cause" of the externality. Work it through with Coase's First and Second Theorems.

9. Adult smokers have 18 years less of life to look forward to than non-smokers. Explain the incentives for a smoker to lie to an insurance company about his smoking. Why would the company do badly if it could not see through such lies? Explain by analogy with the auto "lemons" why non-smokers would do badly in the insurance market if the companies could not see through the lies.

10. Maria suggests that markets do not work because of the uncertainties. Discuss.

11. Discuss the role of institutions in market societies. Give a few examples.


1. A higher price for gas will discourage potential buyers of big cars. So the demand for big cars will shift to the left, as in the diagram. The supply of cars will shift in a little as well because of the increase in production costs. As a result fewer big cars will be sold at most likely a lower price.

2. Governmental support of the poor is inefficient according to the first Welfare Theorem because it represents a transaction that makes one group (the poor) better off at the expense of another group (the taxpayers). Klamer's response is that the outcome of poverty is due to imperfections in markets; the political world may decide that correction is desirable even if this means that people (taxpayers) have to make a sacrifice.

3. An airport produces noise as an externality. A solution would be to set up a market for quietness in which the market could buy the rights to make a specified quantity of noise for a price to be paid to its neighbors. There is an alternative solution discussed in the text.

4. Presuming markets work well, we can say that someone's salary tells what his or her work is worth. For if the worth deviates from the salary, the market would correct the situation.

5. In perfectly competitive markets all products are the same. So there is no need for information other than the price.

6. Judging resumes is tough. It is not made easier when people cheat. How to pick out the letters of reference that are sincere from those that exaggerate the qualities of the applicant? Admission officers may become very cautious lest they admit the lemons into school. At times they may not treat the honest applicants as fairly as they deserve.

7. Examples are conventions as that applicants write a statement, do a college tests, include letters of reference, and so on. (You see the convention especially clearly in comparisons with practices elsewhere: you can enter most European universities without a statement, letters of reference or the scores of a test.) You probably have thought of other institutions because there are many.