Points shown suggest the amount of time you might wish to allocate to each question, and will be usedfor grading. BRIEF and well-organized answers are preferred to long, disorganized ones.  Use the back of the exam if more      spaces is needed, making a note on the appropriate question. Be sure that your student ID but not your name is   on thefirst and last sheets. A sign up page will be passed aroundfor you to give your name and ID. Keep your    eyes on your own work.

Remember thatproblems and wording can be changed significantly on the actual Midterm 2.

1.(20 minutes) Assume that there are 1000 people eligible for insurance in a market. Let N be the number of people

buying insurance in a market, and  be the premium. Assume the insurance market is perfectly competitive. The inverse demand function for insurance is:  = 6000 - 5N

The marginal cost function: MC = 5000 - 4N

a) What is the highest premium anyone is willing to pay for insurance?

b) What is the average cost function?

c)  Find the market equilibrium if there is no government intervention in this market. Put a box around the equilibrium premium and quantity.

d) Draw a diagram showing this equilibrium and the welfare losses to people going without insurance. Label the axes.

e) What per capita tax on people not choosing to buy insurance will induce everyone to buy insurance?

(15 minutes)

1. This problem, based on Ellis and McGuire (EM, 1986,) is similar to the homework problem but ignores the issue of side payment (bribes), and only considers the possibility that doctors care about a drug’s effectiveness and patient out- of-pocket costs.

Imagine a doctor trying to decide which of exactly two drugs A and B to prescribe for a single representative patient. The factors that enter into the doctor’s utility from prescribing each drug include:

i)  The benefit to the patient expected for each drug, calculated in terms of its efficacy E where without loss of generality we assume EA > EB . Implicitly we assume E is measured in dollars, as in EA is the dollar value of drug A to the patient. Doctors attach a weight α to these patient benefits (efficacy).

iii) The out of pocket (OOP) cost to the patient for each drug, OA = θ PA and OB = θ PB where = θ is the fraction of the drug fee paid by the consumer for either drug, PA and PB  are the prices chosen for drugs A and B, and the

consumer pays the same fraction θ as specified by her health plan.

For simplicity, assume that the marginal cost of both drugs is $0.

The doctor makes no revenue or profit out of prescriptions, but cares only about Ei and Oi .

Hence the doctor’s utility function for drug i is:

Ui = α Ei - β θ Pi where i = A, B

Where 0 <= α  is the EM agency weight assigned to the effectiveness of the drug

0 < =β <= 1 is the utility weight assigned by doctors to OOP costs to the patient

0<= θ <=1 is the consumer cost share paid for each drug

Pi is the price charged by the pharmaceutical company for drug i

Ei is the effectiveness of the drug, measured in dollar terms

.

a)  Write out an expression characterizing the physician’s choice between A and B for the general case without knowing any of the parameters. It should include {α, β, θ,  EA, PA, EB, PB }

b) If the market for drug B is perfectly competitive, what will its price be? Assume this price throughout the rest of the problem.

c) Use the results in a) and b) to solve for the profit maximizing price PA given all of the other parameters.

d) Suppose α = β = θ = 1 (perfect agents and no insurance) PB=0 and that EA – EB = 50, i.e., A is much more $50 more valuable (effective) than B. What will be the profit maximizing price for A to choose, PA?

e) Assume α = 1, β =1/10, EA – EB = 50, and θ = 1/10 (partial insurance). What is the profit-maximizing PA?

f) Now assume α=1/2,  β=1/10, θ = 1/10, and EA – EB = 50. What is the profit maximizing value of PA?

g) If patients have to pay for high drug prices through their insurance premiums, does having the doctor be a better agent for patient welfare (i.e., valuing drug effectiveness more) increase or decrease consumer welfare in this problem? Explain.

Short answers questions or these may be expressed in terms of multiple-choice questions. (3 minutes each)

2.Ellis and Jelovac (2018) discuss movie theatre popcorn pricing and how it differs from most goods being sold. List four features of this market that make it distinctive from most other markets.

3.Ellis and McGuire (JHE, 1986) discuss altruistic and partially altruistic providers in their article. What do they recommend using as a payment system if doctors are only partially altruistic?

4.In the classic Rothschild and Stiglitz (1976) model of adverse selection, there are two types of consumers (high and low risk) that the insurance company cannot distinguish between. Is it possible for the insurer to achieve separate contracts for each type (a separating equilibrium) with both parties obtaining full  insurance? Why or why not? What separating equilibria are possible?

5.Briefly describe the main features of the Affordable Care Act by naming one of the problems it was trying to address (hint: there are two, maybe three main ones) and one of the solutions it proposed (hint: there  are three main ones).

6.Many of the Irrationality Game cards discussed in class represent behavioral economics concepts. Be sure you can define and recognize each of the following “irrational” behaviors. (Hint: You might have to look at sources        outside of the class readings to find specific definitions.)

a.   Altruism:

b.   Framing:

c.   Endowment effect:

d.   Affective forecasting:

e.   Default choices:

7.   Also be sure you can define and recognize the difference between moral hazard and adverse selection in health care markets. Be able to give examples of each.

8.   What problems does risk adjustment aim to deal with? What is the basic principle by which it works?

9. (10 minutes)

The classic lemons problem assumes that consumers cannot detect the value of cars before buying them and hence only offers the average price of cars actually on the market. But consumers may be able to detect some but not all of the value variation and adjust their willingness to pay according to knowing which types of cars will be offered. They may also value cars at more than their true value ex post (for example, they really need a car). Suppose that there are equal proportions of three kinds of cars in a    market (1/3) with value to sellers and value to (partially informed) buyers as shown.

A

B

C

Value

to seller

10000

6000

2000

X

______

______

2000

Value

to buyer

11001

7001

5001

Y

_____

_____

_____

a) In column X fill in the two remaining blanks with average value of cars to SELLERS if (ABC), (BC) and (only C) types of cars are offered, respectively. To help you, the (only C) value is filled in.

b) In column Y fill in the three blanks with the average willingness to pay for cars to BUYERS if (ABC), (BC) and (only C) types of cars are offered, respectively.

c)  What is the market equilibrium in this problem?

10. Ellis and Jelovac (2018) focuses primarily on the case where insurance takes the form of a constant         coinsurance rate theta (9) such that PD = 9PS . This problem asks you to think about optimal pricing in the presence of a fixed deductible D with a negotiated price ceiling Pc allowed to suppliers.

a.   Draw a graph illustrating the price- and quantity-setting monopoly outcome in the case of (i) no insurance and (ii) zero marginal costs.

b.   Draw a complementary graph showing how this changes in the face of a constant coinsurance rate e < 1.

c.   In many insurance plans, individuals have to pay a certain amount D upfront (100%) before           coinsurance begins to apply. Draw a new graph that synthesizes the demand shown in (a) and (b)   with a deductible. (You may choose to place the deductible anywhere in the interior of your graph, but make it so that there are two clearly visible regions; one where the deductible hasn’t been met and one where it has). Based on your graph, has the optimal monopolist’s price/quantity changed?

d.  Now suppose that there is a price ceiling Pc  imposed on suppliers. Draw a new graph that adds   this to your solution in (c), but ensure that Pc  is below your current equilibrium. What is the new equilibrium?

11. This problem builds upon Ellis and Jelovac (2018) model of innovation. Assume that social planners      have decided that gaining a year of life is worth $120,000 and that $120k/year is the tradeoff used to      decide whether a new product is cost effective: drugs with a cost of less than $120k per year (or $10,000 per month of life saved) are considered socially valuable. For simplicity assume all cancer patients are   identical and that they value a year of their life gained at $120,000 per year.

a)  Assume that the EXISTANT firm produces Drug E for cancer treatment. It is evaluated in terms of its benefits to consumers (measured as years of life saved) and its cost (measured as cost per treatment).   Draw a diagram (labeling your axes) with the gain in life expectancy on the horizontal axis and cost of treatment on the vertical axis. Locate the existing Drug E on these axes assuming it increases a             patient’s life expectancy by 1 month relative to no drug and has a price per treated patient of $10,000.  What is the cost per year of life gained for this existing drug E?

b)  What does the Hippocratic Oath have to say about whether a new drug will be adopted or not? Lightly shade in the region which is deemed unacceptable for new drugs on due to the Hippocratic Oath.