Economics 321 Midterm

Prof. Bryan Caplan

Fall, 2003

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. Suppose that product demand for tomatoes is relatively elastic. Initially, the minimum wage is below the market-clearing wage for tomato farmers, so it has no effect.


T, F, and Explain: The minimum wage will never cause unemployment as long as tomato farmers' productivity rises at a faster rate than the minimum wage.


FALSE. Since the product demand is relatively elastic, increasing productivity will raise labor demand. However, a rising minimum wage could still cause unemployment, depending on the shape of the labor supply curve. For example, if the supply of tomato farmers is flat, then it doesn't matter how quickly demand is rising: the market clearing wage stays the same, and eventually the minimum wage will matter.



2. Suppose the government passes a law that prevents employers from monitoring their workers with video cameras. Defenders of the law assert: "It will really benefit employers because workers' wages will fall as a result."


T, F, and Explain: Workers' wages will actually rise due to the ban, so employees are better off but employers are worse off.


FALSE. Workers' wages will fall: decreased productivity due to increased shirking reduces demand, and increased opportunity to shirk increases supply. Equally importantly, BOTH employers and employees are worse off: If employees valued the shirking more than employers disvalued it, a mutually beneficial pay cut would already have been negotiated.



3. "But while hypocrisy has its uses, it also has its dangers above all, the danger that you may start to believe the things you hear yourself saying... Right now, there are important central banks the Banks of Canada and France are the obvious examples which really seem to believe what they say about wanting stable prices; their sincerity is costing their nations hundreds of thousands of jobs." Paul Krugman, The Accidental Theorist


T, F, and Explain: According to Krugman, central banks' main hypocrisy is pretending that raising wages will not reduce employment.


FALSE. The main hypocrisy Krugman accuses central banks of is claiming that price stability has great benefits and little costs, even though most of them know better (or used to).

4. Thomas Sowell ("Race and Slavery") reports that "The cost of a slave in the American South was about thirty times the cost of a slave on the coast of Africa."


T, F, and Explain: Sowell attributes this to fact that interest rates in the American South were much lower than in Africa.


FALSE. Sowell attributes it to transportation costs, high mortality during the trans-Atlantic voyage, and greater productivity of existing American slaves who were already familiar with American production methods.



5. Suppose the market for education has positive externalities but does not suffer from credit market imperfections.


T, F, and Explain: From the point of view of the marginal student, the PDV of his education would be 0.


TRUE. An investment that earns the normal market rate of return always has a 0 PDV. Credit market imperfections in education would allow the return to education to permanently exceed the normal market rate, implying a PDV>0. So without credit market imperfections, PDV=0 as usual. The positive externalities are irrelevant from the point of view of the marginal student: Since the benefits go to strangers, it doesn't affect the profitability of the student's decision.



6. The estimated return to education falls after controlling for intelligence.


T, F, and Explain: If you take tuition into account, this shows that educating the less intelligent is especially likely to be a bad investment.


TRUE. More intelligent people earn more controlling for education, but tuition costs the same for all people, regardless of their IQ; therefore the percentage gain for the more intelligent is greater even if the percentage increase in their earnings is average.


This is easiest to show with an example. Suppose that tuition costs $10,000. Suppose further that a more intelligent person who got one more year of school would get a raise from $50,000 to $60,000, while a less intelligent person would get a raise from $25,000 to $30,000. Ignoring tuition, the return is 20% in both cases ($10,000/$50,000=20%; $5000/$25,000=20%). But counting tuition, the more intelligent has a return of $10,000/($50,000+$10,000)=16.7%, while the less intelligent has a return of $5000/($25,000+$10,000)=14.2%.



Salary w/o 1 more yr

Salary w/1 more year


Return not counting tuition

Returning counting tuition


















Part 2: Short Answer

(20 points each)

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



1. On balance, would the elimination of immigration restrictions benefit you personally? Why would you expect to benefit more or less than the average person already living in the U.S.? Try to consider all the main indirect effects as well as any direct ones.


It would be almost a pure gain for me: My wife and I are both highly skilled, so we would face little additional competition in the labor market but pay less for all products requiring unskilled labor. That includes nannies, butlers, etc. In addition, I own a home and stock, both of which should go up in price as a result of increased immigration. (My stock in Emerging Markets might go down, however, as decreased labor supply raises Third World wages). In all likelihood, though, I would gain much more than most Americans, who are on average less skilled, and own less real estate and stock.



2. Average IQs increased substantially over the last fifty years. What would the predicted effect be on Aggregate Labor Markets? The markets for high- and low-skilled workers? Are these predictions roughly consistent with the observed facts during this period? Explain your conclusion, stating any critical assumptions you need to make.


The effect on Aggregate Labor Markets is clear: more productive workers mean higher ALD, raising average real wages. The effect on skilled versus unskilled workers is more complicated. Assume that the products of skilled labor have a relatively elastic demand, while the products of unskilled labor has a relatively inelastic demand. Then greater productivity raises demand for skilled workers, but reduces it for unskilled workers. At the same time, however, the increase in intelligence should enable some low-skilled workers to become high-skilled workers, leading to an increase in the supply of high-skilled workers and a decrease in the supply of low-skilled workers. Bottom line: Average wages go up, but the distribution of benefits is ambiguous. Since average wages have gone up during this period, the one clear prediction is confirmed.