Economics 321 Midterm

Prof. Bryan Caplan

Fall, 2004

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 a new study finds that not working is the number one cause of unhappiness. People believe this study and change their behavior accordingly.


T, F, and Explain: In the Aggregate Labor Market, the quantity of hours worked definitely goes up, but wages could go up or down.


FALSE. ALS increases because people now want to work more at a given wage. But there is no reason for ALD to increase productivity per hour is still the same. Therefore hours goes up, and wages go down.


2. T, F, and Explain: Safety regulation makes jobs less scary, but also reduces wages, so it is impossible to say if the benefits to workers are worth the costs.


FALSE. As a rule, the benefits will be less than the costs. If the benefits to workers were worth the cost, there would be no need for safety regulations. Employers would happily offer more safety in exchange for lower wages.


Exception: One particularly clever answer mentioned that safety regulations might simply order firms to provide the safety levels they would have provided anyway. Unlikely, but possible.


3. "Think of it this way: Imagine several cities, all suffering from housing shortages because of rent control, agree to make it easier for landlords in one city to own buildings in another. This is not a bad idea." Paul Krugman, The Accidental Theorist


T, F, and Explain: Krugman's point is that European integration will force European countries to deregulate their labor markets.


FALSE. Krugman doubts that integration will have more than a small effect, because the "heart of the problem" (p.36) is labor market regulation. In fact, he argues that integration is probably making European unemployment worse by requiring balanced budgets and tight monetary policy.







4. Suppose the country's nominal minimum wage in 2004 is $10/hr, and there is 10% inflation per year. The market-clearing real wage - $9/hr in 2004 dollars - will not change until 2010.


T, F, and Explain: After two years, the labor surplus will have turned into a labor shortage.


FALSE. In two years, the labor surplus will have disappeared, and markets will clear. After one year of 10% inflation, the real minimum wage falls to $9.10 still a little above the market-clearing real wage. But after two years, the real minimum wage is only $8.26, below the market-clearing real wage. And as usual, a MINIMUM wage below the market wage has no effect. It is like a law forbidding the same of Ferraris at any price below $100.


5. Suppose that all slaves have the same MVP, and their owners know this.


T, F, and Explain: There is no possibility that a slave will be paid more than subsistence.


FALSE. There is no longer any self-interested reason to pay more than subsistence, because employers can simply punish any slave who performs below potential. But owners might still pay their slaves more out of altruism - "the kindness of their hearts."


One clever answer observed that owners might pay extra because they know their slaves have the same MVP, but not necessarily what that MVP is.


6. "If the worker has good alternative employment opportunities, the threat to fire him if he helps the union may be empty. If he does not have good alternatives, it is probably because he has... firm-specific human capital... This will make him more productive than he would be working for another firm, implying that he will be receiving a higher salary than he would if he lost his job and went to work for another firm, but also implying that the cost to the employer of firing him will exceed the presumably modest cost of finding a replacement worker." (Posner, Economic Analysis of Law; emphasis added)


T, F, and Explain: Posner's analysis would change if workers knew their firm's reputation before they started working there.


TRUE. Reputation makes firms more willing to fire. Firing union-organizers helps deter potential trouble-makers from seeking employment at your firm. The only workers who would need a large premium to accept this risk to their firm-specific human capital would be those intending to organize unions.


Part 2: Short Answer

(20 points each)

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



1. Europe has significantly higher levels of labor market regulation and lower rates of immigration than the United States. Why would we expect these two policies to go together? Give TWO different reasons.


Reason #1. In heavily regulated labor markets, there are usually extensive unemployment and welfare benefits to cushion the blow of joblessness. With open immigration, these benefits would attract a lot of foreigners hoping for free money. Immigration restrictions make it cheaper to help the domestic unemployed.


Reason #2. Heavily regulated labor markets have high unemployment, especially for low-skilled workers. (Minimum wage laws have a much bigger effect on unskilled labor, for example). Since immigrants tend to be unskilled, this means that it will be hard to find a job in Europe. Immigrants may decide that they would rather have a low-paid job at home than no job at all in Europe.


Another interesting reason one student suggested: Europeans just like regulation more than Americans, so they have stricter versions of both our labor and our immigration laws.



2. Policy analysts often argue that the best way to fight poverty is to focus resources on poor young children, rather than poor mature adults. Does this make sense from the standpoint of human capital theory? Why or why not? Does it matter if, as many intelligence researchers argue, it is almost impossible to permanently change a person's IQ?


There are two obvious reason to focus on kids rather than adults. First, the opportunity cost of kids' time is lower. Second, kids can benefit from any training for more years. However, one factor that cuts against this is that a young child will not enter the job market for a decade or more. Adults benefit for fewer years, but they benefit SOONER, which raises the PDV of training them.


One common argument for focusing on kids is that it is possible to "remold" the young, but not the old. The difficulty of changing IQ undermines this argument. It is hard to remold both the young and the old. Resources focused on young children are not going to make them smarter for life. If you thought otherwise, the case for focusing on kids just got weaker.