Economics 321 Midterm

Prof. Bryan Caplan

Fall, 2006


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.  Since the start of the war with Iraq, the U.S. military has often complained about the "shortage" of new recruits. 


T, F, and Explain:  This is not a "shortage" in the sense that economists use the word.


TRUE.  For economists, a labor shortage is a situation where – at the market wage – labor demand exceeds labor supply.  The military's problem, in contrast, is that, given the market wage for wartime labor and its budget, it does not want to hire additional labor. 


The military's real complaint is that labor is too expensive, not that labor is unavailable at that expensive wage.


2.  Suppose most garbage men have a rare condition: they lack a sense of smell.  Then someone develops an amazing new gas mask that comfortably protects all people from foul odors.


T, F, and Explain:  The invention of this new gas mask will make it harder to unionize garbage men.


TRUE.  The gas mask increases the supply of garbage men AND makes that supply much more elastic.  Both of these factors make it harder to organize unions.  The larger the number of workers in an occupation, the harder it is to get them all to join the union.  The more elastic the supply of workers, similarly, the greater the tendency of higher wages to attract "scabs" eager to undercut the union.


3.  The government passes a new law requiring employees to provide workers with free health insurance.  Nominal wages are unable to fall, but inflation is positive.


T, F, and Explain:  In the short-run, everyone who wants to work benefits from this law.  In the long-run, however, there will be a negative effect on employment.


FALSE.  In the short-run, workers who remain employed benefit, but some workers will lose their jobs and have neither income nor health insurance.  The surplus equals the difference between the new higher supply and the new lower demand at the old wage.  In the long-run, however, inflation will erode the real value of the nominal wage, and eventually restore full employment.


4.  "Malay and Indonesian slaves were sometimes transported thousands of miles away to South Africa at a time when Africans were being transported thousands of miles to the Western Hemisphere." (Thomas Sowell, Race and Culture)   

T, F, and Explain: Sowell admits that economics cannot explain these trading patterns.

FALSE.  Transporting slaves to locations distant from their homes reduces enforcement/ monitoring costs for slave-owners.  Slaves who are unfamiliar with their area, and who are physically or linguistically different from locals, will find it harder to escape.  As Sowell puts it, "Enslaving people on their home grounds was more likely to lead to successful attempts at escape than where they were enslaved far from familiar surroundings."


5.  T, F, and Explain:  A minimum wage for slaves helps slaves and free workers, but hurts slave-owners and employers of free workers.


TRUE.  A minimum wage for slaves makes slaves better off by forcing their owners to give them more than their bare subsistence.  This in turn makes slavery less profitable and reduces the demand for slaves.  Since free workers are a substitute for slaves, demand for free labor goes up, making free workers better-off and their employers worse off.


(Many students' incorrectly assumed that the minimum wage applied to both slaves AND free workers.   I gave these answers partial credit).


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.  Students pay the same tuition regardless of intelligence, but more intelligent students get a larger total benefit, implying a higher rate of return. 


Consider this simple example: Students with average IQ earn $20,000 without a college degree, and $22,000 with a year of college.  Students with high IQ earn $30,000 without a college degree, and $33,000 with a year of college.  Ignoring tuition, the return to education is 10% for both groups.  However, if tuition costs $10,000, average IQ students have a return of $2000/($20,000+$10,000)=6.7%, and high IQ students have a return of $3000/($30,000+$10,000)=7.5%.






Part 2: Short Answer

(20 points each)

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


1.  In Economic Sophisms, Bastiat writes:


If man were a solitary animal, if he worked solely for himself, if he consumed directly the fruits of his labor—in short, if he did not engage in exchange—the theory of scarcity could never have been introduced into the world.


Use two labor supply and demand diagrams to show that what Bastiat calls the "theory of scarcity," may be true for a single occupation, even though it is false for the economy as a whole.  Carefully label both diagrams.


In a single occupation, a fall in workers' MPP increases MVP – and labor demand – as long as product demand is relatively inelastic.  In one occupation, then, lower productivity can increase wages and make workers better off.  In contrast, for the economy as a whole, a fall in workers' MPP always decreases MVP.  For the economy as a whole, then, lower productivity automatically reduces average wages and makes the average worker worse off.














2.  What is the difference between "externality" arguments for subsidizing education and "credit market imperfection" arguments for subsidizing education?  Discuss one kind of evidence that undermines one argument, but not the other.


According to "externality" arguments, when a person gets more education, there are positive side effects for society – like less crime or better voting.  In this scenario, the private return of education is normal, but the social return is unusually high.  According to "credit market imperfections" arguments, in contrast, education has an unusually high private return because – due to collateral problems – it is hard to get an educational loan.


Controlling for IQ undermines the credit market imperfections story by showing that the private return to education is not as high as it looks.  But controlling for IQ does not undermine the externality story, because the externality story does not predict abnormally high private returns for education in the first place.