Economics 321 Midterm

Prof. Bryan Caplan

Fall, 2010

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 the government passes a law requiring “profit-sharing”; every year, firms must give at least 50% of their profits to their workers.

T, F, and Explain: As long as wages are flexible, wages will fall, leaving workers’ well-being unchanged.

FALSE. As with any other mandated benefit, labor demand will decrease and labor supply will increase, so wages fall. However, workers will still be worse off, because the profit-sharing regulation makes their income less predictable. One of the services that employers normally provide for workers is implicit income insurance. Mandatory profit-sharing prevents employers from offering as much insurance as workers want.

2. Suppose MPP increases every year by 2%, and inflation is 0%.

T, F, and Explain: A constant nominal minimum wage will lead to increasing unemployment in agriculture.

TRUE. Since product demand for agriculture is inelastic, increasing MPP will constantly decrease MVP, and therefore labor demand. With no inflation, this means that the gap between the minimum wage and the market-clearing wage gets bigger every year – and so does the unemployment problem.

3. “We ask you to be so good as to pass a law requiring the closing of... all openings, holes, chinks, and fissures through which the light of the sun is wont to enter houses...” (Bastiat, Economic Sophisms)

T, F, and Explain: Bastiat is arguing against worker safety regulation.

FALSE. Bastiat is arguing against protectionist regulations that claim to make France richer by reducing productivity. If it’s absurd to try to get rich by blotting out the sun, isn’t it equally absurd to try to get rich by keeping out cheap foreign products?

4. T, F, and Explain: With a volunteer army, wars are bad for taxpayers. With conscription, wars are bad for soldiers.

TRUE. With a volunteer army, war increases the demand for soldiers and reduces the supply of soldiers (since joining the military during wartime is more dangerous). Both of these forces raise the wages of soldiers enough to compensate them for the extra risk – and taxpayers pick up the tab. With conscription, in contrast, you don’t have to increase wages to recruit or retain extra soldiers; you just threaten to jail them if they go AWOL. So when war breaks out, conscripts have to endure extra danger without extra pay.

5. “After an employer incurs the costs of training an employee in some manual craft, that employee can later decide to go work elsewhere... Even if the employee remains, part of the investment can be lost meeting demands for higher wages...” (Sowell, Race and Culture)

T, F, and Explain: Sowell’s argument implies that slaves may actually have more human capital than free workers.

TRUE. Sowell’s argument implies that slave-owners will be more willing to make long-term investments in their slaves’ human capital than employers of free labor – provided, of course, that the extra training doesn’t increase the risk of escape. However (note the word “may” in the question), if free workers can simply agree to work for reduced pay in exchange for general training, their employers would be just as willing to invest in their human capital as slave-owners are in slaves.

6. Suppose workers under-invest in education because of credit market imperfections.

T, F, and Explain: No-interest education loans are the most efficient government response.

FALSE. The whole problem with credit market imperfections is supposed to be that markets fail to equalize rates of return between education and other investments. No-interest loans would encourage inefficiently high investment in education. The most that an efficiency-minded government would do is subsidize education loans to bring the return to education into line with the other areas of the economy. But it would be even simpler for government to make it legally easier to collect on a no-collateral educational loan.

Part 2: Short Answer

(20 points each)

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

1. What would be the main economic effects of a law banning merit pay? Carefully explain your answer.

The most obvious effect: It reduces workers’ incentive to do a good job, reducing productivity, and thereby reducing wages. But this is only the beginning. Reducing productivity also reduces output and overall living standards. Employers might undermine the ban on merit pay by offering more in-kind compensation to better workers – insurance, vacations, company cars, etc. But if additional regulations closed these loopholes, employers might instead decide to raise wages and fire anyone who didn’t measure up. In this case, the result would be permanent unemployment for less productive/meritorious workers.

2. Suppose there are two goods – meals and steel. Here is how much American and Mexican workers can produce in an hour:

	Steel	Meals
American	10	5
Mexican	1	2

Give a simple example showing how Mexican immigration effectively increases American workers’ productivity.

Suppose that an American worker initially works two hours per day, making 10 units of steel and 5 meals in total. Suppose further that with open immigration, the price ratio between steel and meals is 1:1. (This is plausible price, because it gives both Americans and Mexicans an incentive to produce according to their comparative advantage). Then with open immigration, the American can spend TWO hours making steel, produce 20 units of steel, then trade 6 of his units of steel to get 6 meals. As a result, he can now effectively produces 14 units of steel AND 6 units of meals in 2 hours instead of 10 units of steel and 5 meals. Since 14>10 and 6>5, his productivity just went up thanks to immigration.