GET1023 – Thinking Like an Economist

Semester 2, 2016 A
Matriculation number: __________________________

Midterm
Instructions

Please answer the short answer questions on this question sheet and use the bubble form for the
multiple choice questions. Please answer all questions. You have 70 minutes to finish this exam.
Please explain your answers to the short answer questions 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.

Part Α (20 points)

1. The difference principle, as proposed by Rawls:

(a) Allows social mobility.
(b) Allows exceptional individuals to get richer than others under certain conditions.
(c) Prevents large inequalities between the rich and the poor.
(d) Options (a) and (b).
(e) Options (a), (b), and (c).

2. The endowment effect is due to:

(a) Risk aversion.
(b) The possibility effect.
(c) Loss aversion.
(d) The certainty effect.

3. What is a reference point according to prospect theory?

(a) The point where we stand right now, the status quo.
(b) A point that we feel entitled to.
(c) A point that we used to be at in the past but is now lost.
(d) Options (a) and (c).
(e) Options (a), (b), and (c).
4. Somebody who accepts an unfavorable settlement may be subject to:
(a) The possibility effect.
(b) The certainty effect.
(c) The possibility and/or the certainty effect.
(d) The endowment effect.
(e) None of the other options.

5. Allais’s paradox is a manifestation of :

(a) The possibility effect in the case of losses.
(b) The certainty effect in the case of losses.
(c) The possibility effect in the case of gains.
(d) None of the other options.

6. Given the refined results on altruism generated by the variations of the dictator game, the
results of the original dictator game can be attributed to:
(a) Selection bias: if you are not altruistic, you don’t participate in the game in
the first place.
(b) Scrutiny: the fact that your behavior is under scrutiny by the experimenter hardly
affects your behavior.
(c) Context: the experimenters cannot induce the amount of giving that they desire.
(d) All of the other options.

7. A monopolist:
(a) Increases efficiency because she does not allow non-beneficial transactions to
occur.
(b) Reduces efficiency because she does not allow beneficial transactions to
occur.
(c) Acts irrationally and inefficiently.
(d) None of the other options.

8. Monetary rewards are effective when:

(a) Performance is not responsive to effort.
(b) Intrinsic motivation is sufficiently strong.
(c) Receiving money brings social approval.
(d) All of the other options.
9. System 1:
(a) Cannot be turned off.
(b) Cannot be overruled by System 2.
(c) Options (a) and (b).
(d) None of the other options.

10. Incentives:
(a) Work uniformly across different people.
(b) Can come in the form of recognition, respect, or praise.
(c) Never work differently than expected.
(d) Options (a) and (b).
Part B (30 points)

1. At the moment you submit your answers to this exam, you will fall into a state of
hibernation that will last 1000 years. You will awaken at 2 p.m. on March 3, 3016. One
of the things that will surprise you when you wake up is that almost everybody around
you will be smoking. What is the most likely rational explanation for that observation? (3
points)

A likely explanation for such behavior is that the negative health effects of smoking no
longer exist in 1000 years. Maybe lung cancer can be cured or there is a cancer vaccine or
in any case, such medical advances have been made that smoking is no longer bad for
people’s health. As a result, rational people respond to the elimination of the risks of
smoking by embracing the activity.

2. A new bill introduced in parliament aims at promoting business activity in a country by

reducing the accounting requirements that all firms have to comply with. (Assume that
the requirements were largely redundant and can be safely reduced.) This is good news
for some people and bad news for others. By making arguments based on the theories you
were introduced to in this class, briefly describe and explain the reactions that the new
bill will generate. Also briefly discuss what you expect the outcome of these reactions to
be as far as the bill is concerned. (5 points)

The bill hurts the interests of an organized minority, the accountants. It benefits the firms,
their workers, and society at large. However, due to loss aversion, potential losers, even if
they are few, will be much more active and determined than potential winners.

Accountants, in our case, will ferociously defend their interests by lobbying parliament
and will try to have the bill withdrawn. Since they are few, they will be able to mobilize
themselves effectively, while the general public who stands to gain from the policy is
unlikely to do so. As a result the interests of the organized minority, the accountants, may
in the end prevail.
3. According to Robert Nozick in his book Anarchy, State, and Utopia:

(a) How is the state created? (3 points)

(b) Who are the independents and why do they receive free protection in that state? (3
points)
(c) Nozick argues that this free protection for the independents will not lead to a free-
rider problem. How does he substantiate his argument? (4 points)

(a) The state is created out of the conglomeration of different protective association into one,
the dominant protective association (DPA). We start with many private firms that offer
security and justice services to their members, similar to private security firms or private
insurance firms nowadays. These firms are called protective associations. When a dispute
arises between two people who are clients of different protective associations, there is a
clash between these two associations. The client of the losing association loses faith in
her association, abandons it, and becomes a client of the victorious one. This kind of
process repeated many times over a period of time ends with just one protective
association being the most trustworthy within a certain geographical territory. This
association is the DPA and it is the state for that territory because it has a de facto
monopoly on the use of force.
(b) The independents are individuals who chose not to become clients of the DPA. They are
protected for free by the dominant protective association in their disputes against paying
members of the association because they have been prohibited from defending
themselves in these disputes (using self-help). This is because the DPA deems the use of
self-help against its members as a non-reliable dispute resolution mechanism. This is why
the DPA has a de facto monopoly on the use of force in the geographical territory. As a
result, out of moral obligation, the DPA needs to compensate the independents for having
deprived them of this fundamental right of theirs.
(c) Free protection to independents is only afforded against members of the dominant
protective association and not other independents. So the more independents there are,
the more they will run the risk of not having any protection against other independents.
Therefore, they will be incentivized to become paying members of the DPA. Moreover,
the free protection that the independents are offered is the cheapest one, that is, since they
are not paying, they receive for free the cheapest insurance policy that the DPA can offer.
4. Chaoqun and Han En ordered a pizza from www.caloriesbytheton.com. The pizza had 8
equally sized pieces. Chaoqun and Han En came up with the following options on how to
allocate the pieces:

A B C D E
Chaoqun 5 pieces 7 pieces 4 pieces 1 pieces 2 pieces
Han En 3 pieces 0 pieces 4 pieces 6 pieces 6 pieces

(a) Which options are Pareto efficient? Explain. (3 points)

(b) Chaoqun and Han En never agreed on how to split the pizza and the strongest,
Han En, ate all 8 pieces. After that they never spoke again and Chaoqun has been
blaming Han En for that. He says that the Pareto efficiency criterion would have
never allowed such an uneven split of the pizza. Is his statement right? Explain. (2
point)
(c) Suppose that Chaoqun and Han En had to decide on how to split the pizza behind
a veil of ignorance, as this is described by John Rawls in his book A theory of
Justice. Rank the 5 options (A to E) starting from their most favored. Explain. (4
points)
(d) Rawls makes some assumptions about Chaoqun and Han En’s situation behind
the veil of ignorance that justify their top choice. What are those
assumptions/features of their situation? (3 points)

(a) Pareto efficiency requires all the parts of a resource to be exhausted. In particular, it
requires that no one can be made better off without making somebody else worse off.
In this example, only distributions A, C, and E do that.
(b) Inequality is not considered when we are talking about Pareto efficiency. A
distribution may be completely unequal, such as the one of the question and still be
Pareto efficient, since all the parts of the resource have been used up, even though
only one person gets to use them.
(c) The maximin principle, as envisaged by Rawls, maximizes the utility of the least
favored person. In our example, behind a veil of ignorance, either of the two persons
would choose from most preferred to least preferred the following options: C, A, E,
D, B.
(d) The features of the original position that justify the maximin rule are:
i. In the original position, probability calculations are impossible, or extremely
insecure.
ii. The person choosing cares very little about anything that they might gain
above a minimum level.
iii. The alternatives to the maximin level involve grave risks rendering them
intolerable.