Economics 321 Midterm Answer Key

Prof. Bryan Caplan

Fall, 2001

Part 1: True, False, and Explain

(10 points each - 2 for the right answer, and 8 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:  If demand for food goes up, demand for farm workers always goes up, too.


TRUE.  Labor demand depends on workers' marginal value product, and MVP=MPP*P.  When demand for food goes up, P goes up without changing productivity.  So MVP rises, and accordingly, so does labor demand.


(Most people answered a different question, explaining what happens to demand for farm workers if worker productivity rises).



2.  About 1/3 of all European workers died from the Black Death, an epidemic that struck in the late Middle Ages.  Some governments responded by imposing maximum wages, limiting wages to their pre-epidemic levels.


T, F, and Explain:  These maximum wages would gradually matter less and less as long as inflation were positive.


FALSE.  Maximum wages created shortages, not surpluses, of labor.  As prices rise, the real value of the maximum falls further and further, making the shortage worse.



3.  Some economists "speculate that unionization may enhance productivity, perhaps completely offsetting its monopolistic effects." (Posner, Economic Analysis of Law)


T, F, and Explain:  Posner disagrees with the productivity theory of unionization.


TRUE.  Posner argues that if unions were productivity-enhancing, employers would encourage them instead of fighting them.  More specifically, Posner argues that the productivity theory cannot explain shrinking rate of unionization: "The most telling argument against the productivity theory of unionization is that it cannot explain the decline of the unionized sector." (Posner, p.357)






4.  The cotton gin greatly increased the physical productivity of slaves who picked cotton.


T, F, and Explain:  The subsequent expansion of the Southern slave economy suggests that demand for cotton was relatively elastic.


TRUE.  With elastic product demand, increased MPP raises workers' MVP.  Free workers would see their wages rises.  In slave economies, this raises the demand for slaves, increasing their price and quantity.  If product demand had been inelastic, the cotton gin would actually have hurt slave-owners.



5.  It is easier for well-educated workers to immigrate to the U.S. than it is for unskilled workers.


T, F, and Explain:  This effectively raises the expected return to education in poor countries.


TRUE.  This means that extra education has two benefits in poor countries: first, you earn more money if you stay; second, you increase your chance of getting to move to the U.S. and earn really big money.  On average, then, differentiation immigration treatment encourages education in poor countries.  (Many people pointed out that immigration of educated workers raises wages for educated workers who stay behind.  This is correct, but it misses the really interesting part of the story.  People who gave this answer got partial credit).



6.  Two economic arguments for subsidizing education are externalities and credit market imperfections.


T, F, and Explain:  Both arguments predict that education will have an abnormally high rate of return.


FALSE.  The credit market imperfections argument predicts that education will have an abnormally high rate of return.  The externalities story does not - it suggests that education has a normal rate of return that fails to factor in external social benefits.


Part 2: Short Answer

(20 points each)

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



1.      Krugman ("The Accidental Theorist," pp.18-23) talks about a hypothetical hot dog and bun economy.  Sticking closely to Krugman's example, carefully diagram and explain the effect of greater productivity of hot dog workers in (a) the market for hot dog workers, and (b) Aggregate Labor markets.


In Krugman's example, hot dogs and buns are perfect complements.  Individual product demands are therefore highly inelastic.  As a result, an increase in productivity of hot dog production causes demand for hot dog workers to FALL.  Nevertheless, Aggregate Labor Demand still goes up: productivity gains can hurt workers in individual sectors but always help workers in general.  Thus, average wages still rise.









2.  Imagine studying the "return to exercise" in a primitive economy where workers are mainly paid for brute strength.  Name one important way that merely looking at the earnings of workers who exercise heavily overstates the "return to exercise."  What, in other words, should you control for?  How does this relate to class discussions about the intelligence and the return to education?


You should control for natural strength.  People endowed with greater strength probably find exercise easier and therefore do more of it.  But they still be stronger than average - and earn more than average - if they exercised at the average level.  There is a strong analogy, then, between strength and the return to exercise on the one hand, and intelligence and the return to education on the other.  If you ignore pre-existing ability (strength or intelligence), you tend to overstate the effect of training (physical or mental) on earnings.