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Answer: Once one is on benefit, there may be little or no incentive to work. Once onbenefit, a person need not be lazy to remain on it. It may be rational to remain on benefit ifevery time a person makes a euro, the person loses a euro in benefits.Chapter 21Suppose Marc and Nathalie both buy only two goods: food and wine. Consider whathappens to their purchasing behaviour when the price of food falls.1. It is observed that if the price of food falls, then Marc buys more food and more wine?Explain why this happens.Answer: If the price of food falls then food becomes cheaper relative to wine and Marc willsubstitute additional food for some of the wine he was previously buying. But the fall in theprice of food increases Marc’s real income. (The purchasing power of the Marc’s incomeis increased.) So Marc is buying more wine because his income has increased; and thisincrease due to the income effect is larger than the reduction in his wine purchases due tothe substitution effect.2. It is observed that if the price of food falls, then Nathalie buys more wine but less food?Explain why this happens.Answer: If the price of food falls then food becomes cheaper relative to wine and Nathaliewill substitute additional food for some of the wine she was previously buying. But the fallin the price of food increases Nathalie’s real income. For some goods, some consumersmay buy less when their incomes rise. Such goods are called inferior goods. So forNathalie, food is an inferior good. In fact, because the reduction in her food purchases dueto the income effect is larger than the increase due to the substitution effect, we can saythat food is a Giffen good for Nathalie. Wine, however, is a normal good – Nathalie buysmore of it when her income rises.Chapter 22When you buy motor insurance the policy will generally stipulate that the policyholder isresponsible for the first part of any claim; for example, you might have to pay the first €250or €1,000 of any claim and the insurance company would pay the rest. The amount youwould have to pay is called the deductible.1. How does this arrangement help to deal with the problem of moral hazard?Answer: The problem of moral hazard in this case is that without the deductiblepolicyholders might be less careful to lock their cars when leaving them unattended, andmight engage in other risky behaviour, knowing that if their car is stolen or damaged thenthe insurer will pay all the consequent costs. They would not do this if they weren’tinsured. By forcing policyholders to pay some of the costs of a claim, this behaviour isdiscouraged.2. How does this arrangement help to deal with the problem of adverse selection?
Answer: The problem of adverse selection is that motorists have more information abouttheir driving abilities and habits than do insurance companies, making it difficult for theinsurers to identify high and low risk drivers and charge them appropriate premiums.Stipulating a high deductible on lower premium policies and a lower deductible on higherpremium policies will tend to encourage higher risk drivers to buy the higher premiumpolicies. Lower risk drivers will buy the cheaper policies. So the insurance companies areable to separate high and low risk drivers and overcome the problem of adverse selection.Chapter 23Suppose you are watching a news report with a friend. The news report points out that acertain African nation generates a GDP per capita of only $1,300 per year. Since yourfriend knows that UK GDP per capita is approximately $26,000, he suggests that Britonsare materially 20 times better off than the people of the African nation.1. Is your friend’s statement accurate?Answer: No.2. What general category of production is not captured by GDP in both the UnitedKingdom and the African nation?Answer: Non-market activities such as household production.3. Provide some examples of this type of activity.Answer: Household production done by an individual without pay such as gardening,cleaning, sewing, home improvement or construction, child supervision, etc.4. Why would the exclusion of this type of production affect the measurement of Africanoutput more than UK output?Answer: A greater proportion of the output produced by developing nations is non-marketoutput. That is, it is not sold and recorded as a market transaction.5. Does this mean that residents of the African nation are actually as well off materially asresidents in the United Kingdom?Answer: No. It just means that quantitative comparisons between nations of greatlydifferent levels of development are very difficult to do and are often inaccurate.Chapter 24Suppose you’ve been talking to a friend’s father who told you that he gave up smokingcigarettes in 1995. When you asked him why he quit, you got a surprising answer. Insteadof reciting the health benefits of quitting smoking, he said, "I quit because it was justgetting too expensive. I started smoking in 1965 and cigarettes were only 45 cents a pack.The last pack I bought was €2.00 and I just couldn't justify spending more than four timesas much on cigarettes as I used to."
Page 1 and 2: Advanced Critical ThinkingChapter 1
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Page 26: Answer: Although the level of trade

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