Economics 321 Midterm

Prof. Bryan Caplan

Fall, 2008

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 native-born Americans and immigrants have exactly the same skills.

T, F, and Explain: Immigration will reduce Americans’ average standard of living.

FALSE. If natives and immigrants have the same skills, immigration increases ALS and reduces Americans’ wages. But any decline in wages benefits American employers by exactly the same amount – if workers earn $1/hour less, employers pay $1/hour less. Furthermore, marginal employers who wouldn’t have hired at the old wage benefit from immigration. There are also net benefits for American landowners and consumers (when rents rise by $1, landlords are $1 richer and tenants are $1 poorer; but natives are more likely to own American land than immigrants). When you combine these consequences for Americans’ standard of living – some with zero net effect, the rest with a positive effect – you can conclude that the average standard of living goes up.

2. T, F, and Explain: If wages can’t adjust, increasing the strictness of safety regulations will reduce employment.

TRUE. Stricter regulations reduce labor demand (since employees are now more expensive to hire), and increase labor supply (since jobs are now safer at a given wage). With flexible markets, the result would be a wage decline. If wages don’t adjust, however, the result will be a labor surplus (the difference between the new S and the new D at the old wage) – also known as unemployment.

3. “Productivity growth in one sector can very easily reduce employment in that sector.” (Krugman, The Accidental Theorist)

T, F, and Explain: Unlike Caplan, Krugman argues that this is a serious problem for unregulated labor markets.

FALSE. Krugman, like Caplan, argues that the displaced workers will move into another sector, leaving overall employment the same. That is the whole point of his hot dog/bun example: Higher productivity is always good for the overall economy, but not necessarily for workers in any particular industry.

[Students only got partial credit if they answered using the standard ALS-ALD model from the notes. The question is about Krugman’s view – and whether it differs from what we learned in class.]

4. The Internet makes it easier for people to learn about employers’ reputations.

T, F, and Explain: This makes firms less willing to temporarily overpay inexperienced workers.

TRUE. If firms can build reputations for combining low starting salaries with unusually high raises, they wouldn’t need to temporarily overpay workers to attract them. Workers would know that they are getting a payment package where raises eventually compensate them for their initially low pay. More importantly, firms with good reputations would want to compensate their workers in this way to discourage workers from getting expensive training, then quitting.

5. T, F, and Explain: According to Thomas Sowell (Race and Culture) urban slaves in the U.S. South were treated better because urban slave-owners were more altruistic than rural slave-owners.

FALSE. Thomas Sowell says that the main reason was that urban slaves were harder to monitor: “Urban slaves were much more likely to be able to read or write, since it was costlier to monitor their movements and activities in a city. Moreover, they were more likely to have social contacts among free blacks in the cities. This not only lead to more escapes, it led to better treatment, in order to forestall escapes.” (p.206)

6. IQ tests are a good predictor of job performance.

T, F, and Explain: If IQ tests were culturally biased against immigrants, immigrants would have lower job performance than natives with the same IQ.

FALSE. If IQ tests were culturally biased against immigrants, immigrants would actually have higher job performance than natives with the same IQ. The whole idea of cultural bias is that people against whom the test are biased have more ability than the test gives them credit for.

Part 2: Short Answer

(20 points each)

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

1. Suppose a war breaks out. How does this affect soldiers in a conscript army? How about a volunteer army? Are there situations where the method of recruitment (conscription/volunteer) doesn’t really matter? Use the economics of slavery to explain your answer.

Conscripts are like slaves; volunteers are like free workers. When a war breaks out, the supply of volunteers falls and the demand for volunteers rises, so volunteers get a large pay increase. Furthermore, the military has an incentive to protect volunteers’ safety, health, and so on; otherwise they will have to pay an even higher wage to compensate them for the risk. In contrast, when a war breaks out, there is no need to offer conscripts better wages; if the government needs more soldiers, it can simply order more to enlist. There is also much less incentive for the military to worry about conscripts’ safety or health, because they don’t have to compensate them for the risk. Still, conscripts will not necessarily be badly treated. The government might be an “altruistic” slave-owner that treats conscripts well because they are “Our troops,” the “Defenders of our proud nation,” etc.

2. In the notes, we discuss several different ways to calculate the return to education. If you calculated YOUR return to education using the simplest method (foregone wages are the only cost of school, no control variables), what do you think it would be? What do you think your return to education really is? If your answers differ, carefully explain why.

If I calculated my return to education using the simplest method, it would probably be about 25% - I gave up about $240k worth of income over the course of 8 years of my life (B.A. + Ph.D.) to raise my salary by about $60k per year over the norm for a high school grad. But this number is far too high: If I hadn’t gone to college, I probably would have earned an above average salary anyway (due to high IQ, good work ethic, etc). Furthermore, at least for my B.A.., my family had to pay tuition; that isn’t included in the simplest estimate, but it should be. On the other hand, though, I do really enjoy my job, so looking only at my paycheck underestimate the total benefit. All things considered, my return to education has probably been about 12% per year.

[Note: A return to education is a percent, not a dollar amount. Don’t confuse PDV with rate of return!]