Nick’s friend Fred is a big, strong guy. Fred will not allow anyone to harm Nick

Question

Nick’s friend Fred is a big, strong guy. Fred will not allow anyone to harm Nick. Nick enjoys teasing people. In fact, Nick’s marginal benefit (MB) of teasing people is given by: MB (Q)=75- 10Q, where Q is the quantity of people teased. Generally, people do not enjoy Nick teasing them. Thus, they retaliate to Nick’s teasing. Without Fred around to protect Nick from the retaliation, Nick’s marginal cost (MC) of teasing people is MC (Q) = 20Q due to the retaliation. However, with Fred around, Nick perceives his marginal cost of teasing to always be zero as nobody will retaliate with Fred around. This is because Fred will step in to protect Nick from the retaliation.

A - Without Fred around, what is Nick’s choice for teasing?

B - How much does Nick increase teasing when Fred’s around?

C - Is Nick’s behavior characteristic of a moral hazard? Explain why or why not?

Explanation / Answer

(A)

MB (Q)=75- 10Q

MC (Q) = 20Q

so MB - MC (Q) = 75-30Q

Till the point, MB - MC > 0, Nick is fine,

so 75 - 30Q > 0

Q < 75/30

Q < 2.5

so Nick can tease at most 2 people.

(B)

so MB - MC (Q) = 75-10Q

with Fred around as, MC = 0

75 - 10Q > 0

so Q < 7.5

so With Fred around, Nick can tease 7 persons.

C.

His bevaior is  characteristic of a moral hazard because when he is with Fred, he starts teasing people almost 3.5 time more than being along. That says, he is not a moral person.

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