Economics 321 Midterm Answer Key

Prof. Bryan Caplan

Fall, 2000

Part 1: True, False, and Explain

(10 points each - 3 for the right answer, and 7 for the explanation)

State whether each of the following six propositions is true or false.  In 2-3 sentences, explain why.  Use diagrams if helpful.


1.  T, F, and Explain:  Increasing unemployment insurance payments during the Great Depression (when the unemployment rate was around 25%) would have reduced the level of involuntary unemployment.


TRUE.  Unemployment was enormous because the market wage was far above the market-clearing wage.  Increasing unemployment insurance payments reduces the S of labor.  Holding wages fixed, this shrinks the gap between labor demanded and labor supplied.  The increase in payments "converts" involuntary unemployment into voluntary unemployment.


2.  Suppose there are two kinds of jobs teenagers are able to do: collecting tickets at movie theaters (an OK job with a free-market wage of $4.00), and telemarketing (an unpleasant job with a free-market wage of $10.00).  The teenagers' parents kick them out of the house if they don't have a job, so teenagers prefer any job - however bad - to unemployment.


T, F, and Explain:  Imposing a $6.00 minimum wage indirectly raises wages for telemarketers.


FALSE.  The minimum wage creates a labor surplus for ticket-collectors (minimum wage exceeds markets wage), but has no direct effect on the telemarketing market (market wage exceeds minimum).  However, since these teenagers have to get a job, unemployed would-be ticket- collectors switch to telemarketing.  The S of telemarketers increases, driving telemarketers' wages down.


3.  T, F, and Explain:  Krugman ("A Good Word for Inflation") argues that mild inflation helps increase workers' real wages.


FALSE.  Krugman argues that mild inflation helps reduce real wages because workers resist nominal wage cuts more fiercely than real wage cuts.  At any given time, shifts in demand mean that some workers' real wages need to fall to clear the market.  Mild inflation, Krugman argues, makes it easy for these necessary real wage cuts to happen.







4.  Suppose gold is mined by slaves, and the demand for gold is relatively inelastic.  Someone invents a new process that increases the amount of gold a slave can mine in a day.


T, F, and Explain:  Slave-owners are worse off as a result of this invention.


TRUE.  Productivity increases mean S increases in the product market.  With relatively inelastic demand for gold, price falls a lot compared to the rise in the quantity a worker produces.  Thus, MVP=P*MPP falls and labor demand falls.  Since a slave's market price is just the (lifetime discounted value) of MVP minus costs of subsistence and monitoring, the price of slaves declines.  Slave-owners are thus worse off because the value of their investment falls.


5.  Professors with Ph.D.'s often earn less money than students fresh out of business school, even though the Ph.D. degree takes much longer to complete than the M.B.A.


T, F, and Explain:  The only explanation human capital theory could offer is that - even before they started their graduate programs - the M.B.A.'s had more ability than the Ph.D.'s.


FALSE.  Another explanation consistent with human capital theory is that professors pay a compensating differential to have a more "fun" job.  Human capital theory does not rule out non-monetary concerns.  (A few people suggested intelligence as an explanation, but that seems like a clear example of ability to me.  A few others suggested Conscientiousness, which one might argue is different from ability.  I gave these close to full credit.  A few others argued that Ph.D.'s would earn more in the future.  The question wording (which compares professors to "students fresh out of business school) weighs against this interpretation, but I gave it moderate partial credit).


6.  T, F, and Explain:  All else equal, the rate of return on education will be lower for a women who plans on taking a few years off from work to have children.


TRUE.  Education raises earnings for people who work.  If a woman takes time off from work, she captures the wage premium of education for fewer years.  Since the costs of education (foregone earnings, tuition) stay the same and the lifetime benefit of education falls, the rate of return to education falls. 





Part 2: Short Answer

(20 points each)

In 4-6 sentences, answer both of the following questions.  Use diagrams if helpful.



1.      Sowell ("Race and Slavery") explains that "many slave owners nevertheless found it expedient to use other incentives than force."  Briefly describe two examples from Sowell: one where such incentives were used, and one where they were not.  Then provide a clear economic argument - either Sowell's or your own - to explain this difference.


Sowell compares slaves involved in mining (few non-force incentives) to slaves involved in running the Ottoman bureaucracy (many non-force incentives).  He attributes the difference to "the nature of the work."  In mining, force alone is sufficient to make people work hard at their job.  It is easy to judge ability, and force people to work up to their ability.  In contrast, in the Ottoman bureaucracy, it was important to induce able slaves to reveal their talents; it is not easy to judge who will be a good administrator just by looking at him.  In such cases, slave-owners increase their own income by offering their slaves positive incentives.











2.  Suppose the next president pushes through a bill requiring all employers to provide their workers with free health insurance.  What happens in the labor market if wages are permitted to change?  What happens if the government makes it illegal to change wages in response to the legislation?


Labor demand decreases because each worker is now more expensive to hire; labor supply increases because holding wages constant, jobs are now more pleasant to get.  If wages can fall, this bill reduces wages.  If it is illegal for wages to fall, there is surplus labor - involuntary unemployment.  There is a wage floor at the old market-clearing wage, and unemployment equal to the difference between the new supply curve and the new demand curve at that wage.