Economics 321 Midterm

Prof. Bryan Caplan

Fall, 2007

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:  Increased demand for food is actually bad for farmers, because the demand for food is highly inelastic.

FALSE.  Regardless of the elasticity of the demand curve, an increase in demand raises price in the product market, raising workers' MVP=MPP*P, and raises labor demand for farm workers.  Farm workers are therefore better off.

2.  A firm hires a worker for \$30,000.  A year later, it sells the products the worker made for \$33,000.

T, F, and Explain:  The firm exploited the worker by paying him less than the market value of his output.

FALSE.  One of the functions of employers is to serve as implicit lenders to workers: Employers pay workers now for products that will only be sold in the future.  It is entirely expected, then, that if employers have to wait a year before they complete the sale, the sale price will be higher than wages paid.  In effect, the worker borrowed his wages at an interest rate of 10%.

3.  Suppose the government passes a law requiring Wal-Mart to provide free health insurance to all of its workers.  Wal-Mart does not cut its workers' wages because it is afraid of a public outcry.

T, F, and Explain:  There will still be negative side effects for workers of this regulation.

TRUE.  The mandated benefit increases the supply of workers (more people want a job at a given when it includes health benefits), and decreases the demand for workers (Wal-Mart is less willing to hire workers at a given wage when it has to give them insurance too).  If wages cannot fall, the result is a labor surplus – in other words, unemployment.  Much of this unemployment will probably take the form of reduced expansion by Wal-Mart.  In the long-run, though, inflation will gradually erode the disemployment effect, so workers will eventually pay for their own insurance in the form of lower wages.

4.  "[T]he belief that absolute price stability is a huge blessing... rests not on evidence but on faith.  The evidence actually points the other way: The benefits of price stability are elusive, the costs of getting there are large, and zero inflation may not be a good things even in the long run." (Paul Krugman, The Accidental Theorist)

T, F, and Explain: Krugman is arguing that inflation can reduce unemployment without reducing real wages.

FALSE.  Krugman argues that inflation can reduce unemployment BY reducing real wages.  If nominal wages stay fixed, inflation covertly reduces real wages – allowing the economy to avoid unemployment caused by nominal rigidities.

5.  Suppose both slaves and free workers are engaged in cotton picking.

T, F, and Explain:  If slaves form a labor union, it would be good for them, but disemploy free workers.

FALSE.  If slaves form a labor union, it will be good for them.  A successful slave union could extract higher pay and better treatment for slaves.  This would reduce the demand for slaves, but slave-owners, not slaves, pay the price.  Furthermore, since free labor is a substitute for slave labor, the slave union would increase the demand for free workers, making them better off as well.

6.  T, F, and Explain:  One serious problem with human capital theory is that it ignores non-monetary costs and benefits.

FALSE.  Human capital theory allows you to count ANYTHING; all you have to do is assign a monetary value to it.  Thus, if some jobs are fun and others are unpleasant, HCT tells you to put a price on that fun/unpleasantness.  Then you factor those prices in your calculations, and make whatever choice has a higher PDV, all things considered.

(20 points each)

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

1.  "In markets for specific occupations, labor demand sometimes behaves counter-intuitively.  In aggregate labor markets, labor supply sometimes behaves counter-intuitively."  Explain.

Specific occupations: We would intuitively expect that when workers' MPP goes up, labor demand would automatically go up, too: More output, more pay, right?  However, in markets where product demand is relatively inelastic, higher MPP leads to lower MVP, so labor demand goes down.

Aggregate Labor Markets: We would intuitively expect that when wages rise, people will work more hours.  That's how individual labor markets work, after all.  However, in Aggregate Labor Markets, it is quite possible for the ALS curve to have a negative slope.  All it takes is an income effect bigger than the substitution effect.  In this case, when wages go up, hours worked go down.

2.  In If You Lived 100 Years Ago, Ann Mcgovern asks why the standard of living of the poor has improved since the 1890's.  Her answer:

Not all rich people were selfish. Many cared about the poor. A newspaper reporter, Jacob Riis, wrote a book called How the Other Half Lives. Riis's photographs showed people living and working in miserable conditions. Men and women who cared about the way the poor lived began to work for changes...

In the 1900s, laws were finally passed to protect children. New laws said all children under the age of fourteen had to go to school. They were laws that called for better housing, safer foods and medicines, shorter working hours, and improved public schools. Things began to look up for many people. (from If You Lived 100 Years Ago, by Ann Mcgovern)

Use what you have learned in class to provide an economically sound answer to Mcgovern's question.

While Mcgovern credits philanthropy and regulation, this can't be right.  Why not?  Because even if you equalized income in 1890, and even if this had no effect on production, average living standards would still have been extremely low by modern standards.  The big difference between then and now is that we produce a lot more stuff per person than we used to.

The right answer to Mcgovern's question is that workers' productivity massively increased, largely as a result of technological progress.  As productivity went up, so did Aggregate Labor Demand, and so did wages.  If modern regulations had been imposed in 1890, their main effect would have been to disemploy most of the population – not to magically increase living standards to modern levels.