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Announcements: Tuesday Breakout sections: Nike case, hard

midterm questions You have gotten an Oncourse

email from me with details about the midterm grades. Your grade is posted on Oncourse.

Next week: international trade. Look back to the economics readings

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Announcements: Thursday Breakout sections: Chiquita case

You have gotten an Oncourse email from me with details about the midterm grades. Your grade is posted on Oncourse.

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G302, Week 8

Information

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ENRON

Does this indicate market failure?

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ENRON

EXXON

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Information is always imperfect. So why do we say imperfect information causes market failure?

What you will learn today

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How Much Safety Do We Want?

What are the leading causes of death in the United States?

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Causes of Death in the US, 1991

0

100

200

300

400

Heartdisease

Cancer Stroke Lungdisease

AccidentsDeat

hs/1

00,0

00 p

eopl

e

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Accidental Deaths in US, 1991

0

5

10

15

20

MotorVehicle

Falls Poison Drowning Fires,burns

Deat

hs/1

00,0

00 p

eopl

e

10

How Much Safety Do We Want?

Marginal BenefitOf More Safety

Marginal CostOf More Safety

Safety features

$$

S*

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Car Safety Ratings http://www.nhtsa.dot.gov/NCAP/Cars/2001Cmpt.htmlPosted 01/15/2002

Compact Passenger Cars,

front driver, side

2001 Chevrolet Cavalier 2-DR. 3 1

2001 Dodge Neon 4-DR. 4 3

2001 Ford Focus 2-DR. 5 4

2001 Honda Civic 4-DR. 5 4

2001 Pontiac Sunfire 4-DR. 4 1See also: http://www.nhtsa.dot.gov/NCAP/Info.html#iq8

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How Much is a Life Worth?People take risks all the time. Suppose: an office job pays $40,000 and has a 1/1000

chance of accidental death a field job pays $50,000 but has a 3/1000

chance of accidental death then the field job is paying $10,000 for a

2/1000 risk If you take it, you value your life less than

$5M ($10,000*1000/2)

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To Raise Your Annual Death Risk by One in 1 Million:

Smoke 1.4 cigarettes (cancer and heart disease) Work 1 hour in a coal mine (black lung disease) Travel 6 minutes by canoe (accident) Travel 150 miles by car Fly 1000 miles by jet Live 2 months in Denver instead of Indiana (cancer) Drink 1000 24-oz. drinks from banned plastic

bottles (cancer) Live 2 months in the average stone or brick building

(cancer)

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How much would you have to be paid to accept a 1 in 100 probability of instant, painless, death?

How about a 1 in 100,000 probability?

Write the amount on a notecard.

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Summary: the Value of Safety

People do not really want to pay for maximum safety any more than for maximum quality. Otherwise they wouldn’t drive cars or live in New York.

By their deeds, people put dollar values on their own lives.

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Is there market failure? Just because people buy unsafe

products does not mean there is market failure

But if people consistently underestimate (or overestimate) the danger of what they do, that creates market failure.

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A car whose brakes sometimes fail...

deceived demand

informed demand

20

10

100

supply

price

quantity

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The deadweight loss is...

deceived demand

informed demand

20

10

100

supply

price

quantity

ABC

DE F

G

H

(a) A+B(b) B+F(c) G(d) E+F(e) D+E+F+G+H

1. Did the sign-in sheet get around? 2. If you answered a question, bring up anotecard for me.

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People May Also Overestimate Danger...

•1962: DDT mosquito insecticide. It does not cause cancer•1972: DES in beef. It does not cause cancer•1976: Red Dye No. 2•1977: Saccharin sweetener•1978: Love Canal toxic waste dump•1979: Three Mile Island nuclear accident•1979: Times Beach dioxin--town evacuated.•1989: Alar•1989: Electric blankets•1990: Benzene in Perrier water•1993: Asbestos in schools•1990s: cigarette smoking (dangerous, but less than the hype)

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What did Enron do wrong?

Write this on a notecard. I don’t care if you are right or wrong--- you haven’t had any readings on this. I just want you to think about what your impression is, as a rationally ignorant citizen.

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Enron’s Raptor I company Enron put up $1000 cash, a note

promising $50M, and $537M in Enron stock, restricted so it could not be sold for 3 years

Enron got back a note promising $400M An outside company, LJM2 put up $30M

cash LJM2 got back a promise of $41M within

6 months

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Hedging Enron Raptor hedged Enron’s Asset X using

“swaps”. Suppose X is worth $40M now. If X went down to $20M, Raptor would owe money to Enron.

Thus, Enron would lose on X directly, but gain on its hedge with Raptor. This would make Enron’s earnings look better.

But what if Enron’s stock goes down? That’s about all the assets Raptor has. Then Raptor couldn’t pay what it owed Enron.

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Effect on Earnings of Raptors I, II, III, IV

Reported

Without Raptors

RaptorsContributi

on

3Q 2000 $364 $295 $89

4Q 2000 $286 -$176 $462

1Q 2001 $536 $281 $255

2Q 2001 $530 $490 $40

3Q 2001 -$210 -$461 $251

Total $1,506 $429 $1,077

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What to remember about Enron Enron set up new companies solely

to make its earnings look good The main asset of these new

companies was Enron stock, so when it crashed, they crashed

Certain Enron executives made a lot of money from the new companies, at Enron’s expense

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Worldcom Worldcom’s CFO capitalized lots of

expenses There is no question this was

against GAAP. It was outright fraud.

Where is the inefficiency?

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Martha Stewart and Imclone

The FDA turned down Imclone’s application for a new cancer drug.

She and herfriend theCEO sold justbefore the crash

Is there market failure here?