Economics The True Risk and The Perceived Risk

CSUN Economics The True Risk and The Perceived Risk Questions

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(1) Propose an answer to the following “economic puzzle of products liability law: the injurer and the victim have a contractual relationship, so why shouldn’t they be left to work out the optimal combination of safety precautions contractually?”

(2) Assuming the generic form from class, show algebraically that when consumers misperceive risk associated with products, the equilibrium outcome will differ from the efficient outcome. What is a solution to this?

(3) Suppose the inverse demand and supply curves for Coca Cola are given by ???? = 60 − 2???? and ???? = ????. There is . 001 chance that a can of Coke will explode, causing $30,000 in damages.

(a) If there is no liability, what will be the market clearing price and quantity? If there is a strict liability rule, what will be the market clearing price and quantity? What is the difference? Explain.

(b) Suppose consumers misperceive the damages of a can of coke exploding by $15,000. If there is no liability, what will be the market clearing price and quantity? If there is a strict liability rule, what will be the market clearing price and quantity? What is the difference? Explain.

(4) Suppose that there are two consumers who derive benefits from consuming one unit of a dangerous product. Consumer A derives total benefits of $200; consumer B derives total benefits of $100. The risk of an accident from consuming the product is .01, and the damages from an accident are $5,000. Finally, the firm’s cost of producing the product is constant at $75 per unit.

(a) Is it efficient for the firm to produce and sell the product to consumer A? What about consumer B?

(b) Suppose that both consumers (and the firm) correctly perceive the risk of an accident. What is the price of the product, and which consumer(s) purchases it under a rule of no liability? Under strict liability? Which rule (or rules) yields the efficient outcome? (Assume the firm is competitive and sets the price equal to its full expected cost per unit.)

(c) Now suppose that both consumers misperceive the risk of an accident to be .001. How does this change your answer to (b)? (Assume the firm continues to perceive the risk correctly.)

(5) Consider two identical parcels of land, each of whose surface value is $1,000 to a potential buyer. The owner of each parcel values the surface at $800, but one of the parcels has contamination that will cost $500 to clean up. The owners know whether their parcels are contaminated, but the buyer does not (that is, the parcels look identical to the buyer). Also, assume that the owner of the contaminated parcel will have to spend the $500 cleanup cost even if she fails to sell it.

(a) Is it efficient for the buyer to acquire one of the parcels? Explain.

(b) What is the buyer’s best offer for a parcel if sellers are fully responsible for cleanup costs? What is the buyer’s best offer if the buyer is responsible?

(c) Show that the seller of the uncontaminated parcel will accept the buyer’s best offer only if sellers are responsible, but the seller of the contaminated parcel will accept the buyer’s best offer under either rule for cleanup costs.

(6) A train derailment in Ohio spills harmful chemicals into the environment. Exposure to these chemicals can lead to illness, which when contracted, costs $240,000 to treat. Without exposure, the probability of experiencing this illness is .1. Accidental exposure to the chemicals increases the probability of getting it to .2.

(a) Under a proportional liability rule, given that the illness has occurred to a victim, how much must the injurer pay out?

(b) Under a tort-for-risk rule, how much must the injurer pay out?

(c) What is the difference between these rules? That is, how do they differ on implementation, on efficiency, on fairness, and on costs to the court system?