Economics 321 Midterm

Prof. Bryan Caplan

Fall, 2012

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:  If you are self-employed, you automatically earn your marginal value product.

TRUE.  MVP=MPP*P, and if you’re self-employed, you automatically earn whatever you physically produce (your MPP) times the market price (P) for your output.  If you earn nothing when you’re self-employed, that shows your MVP is zero.

(I gave partial credit, and in one case full credit, for students who objected that you would have to pay other factors of production, too.  The point is that if you’re self-employed, you automatically earn the full reward for any additional (“marginal”) production).

2. Suppose that in 2012, workers earn a \$50,000 salary plus \$10,000 in health insurance benefits.  The cost of health insurance always rises \$1000 per year in real terms.  Assume (a) employers always provide health insurance, (b) labor demand does not rise, and (c) there is 1% inflation.

T, F, and Explain:  The following table is not accurate.

 Year Nominal Salary Can’t Fall Nominal Salary Can Fall Nominal Salary Nominal Insurance Cost Real Salary Real Insurance Cost Nominal Salary Nominal Insurance Cost Real Salary Real Insurance Cost 2012 \$50,000 \$10,000 \$50,000 \$10,000 \$50,000 \$10,000 \$50,000 \$10,000 2013 \$50,000 \$11,110 \$49,504 \$11,000 \$49,490 \$11,110 \$49,000 \$11,000

FALSE.  The table is exactly correct.  The 2012 numbers are straight out of the question.  For the 2013 numbers, Real Insurance Cost correctly rises by \$1000, from \$10,000 to \$11,000.  Then in the “Nominal Salary Can’t Fall” block, Nominal Salary remains \$50,000, Real Salary=Nominal Salary/1.01 (due to 1% inflation), and Nominal Insurance Cost=Real Insurance Cost*1.01 (due to 1% inflation).  In the “Nominal Salary Can Fall” block, Real Salary falls to keep Real Salary+Real Insurance Cost constant at \$60,000, Nominal Salary=Real Salary*1.01, and Nominal Insurance Cost=Real Insurance Cost*1.01.

(Several students say that Real Salary in the “Nominal Salary Can’t Fall” block should be \$49,500, but the correct formula is Real Salary=Nominal Salary/Price Index, and the Price Index rose from 1.00 in 2012 to 1.01 in 2013).

3. T, F, and Explain:  Licensing an occupation typically improves working conditions for workers in that occupation by increasing demand for their services.

FALSE.  Licensing an occupational typically doesn’t raise quality, so demand shouldn’t change.  The effect of licensing is simply to reduce supply, raising wages.  And as usual, we’d expect better-paid workers to take part of their higher wages in the form of better working conditions.

4.  T, F, and Explain: According to Flynn and Dalmia (“What Part of Legal Immigration Don’t You Understand?”), U.S. immigration laws have little effect on low-skilled immigration.

FALSE.  Flynn and Dalmia show that U.S. immigration laws massively reduce low-skilled immigration.  There are only 10,000 green cards per year for low-skilled workers “and the wait time approaches infinity.”  Realistically, low-skilled workers can only legally immigrate if they have family in the U.S.  Spouses and minor children can get in fairly easily, but all other relatives have to wait years.

5. “While this literature is actively evolving, in no case has one of these recent and rigorous

studies identified a country pair for which large differences in earnings across the

border can be mostly accounted for by self-selection of workers (migrant or otherwise)

who cross the border.” (Clemens, “Economics and Emigration”)

T, F, and Explain:  Clemens is saying that low-skilled immigrants to the U.S. approximately earn the median U.S. wage soon after they arrive.

FALSE.  Clemens is saying that low-skilled immigrants soon approximately earn the typical U.S. wage for natives who have similar skills.  Low-skilled immigrants earn well below the typical U.S. worker, but they don’t earn much less than typical low-skilled U.S. worker.

6.  After graduation, engineering majors make a lot more money than art history majors.

T, F, and Explain: This proves that studying engineering creates more human capital than studying art history.

FALSE.  Engineering might create more human capital than art history, but it’s very likely that engineers also had more human capital before they started college – higher IQ, better work ethic, more determination, etc.  Unless you statistically adjust for these pre-existing differences, post-graduation earnings don’t “prove” anything.

(I gave partial credit to students who pointed out that art history majors might enjoy their jobs more, so properly measured their degrees could have as large a return as engineers’.  This is true, but it overlooks the more fundamental point that comparing earnings ignoring initial ability overstates the effect of education).

(20 points each)

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

1.  Some economists argue that the minimum wage has no effect on employment because employers respond by requiring their workers to work faster.  Use a supply-and-demand diagram to illustrate this story.  If this story is true, do minimum wage laws make the typical worker better off?

This story makes sense as long as product demand is relatively elastic.  In such a market, requiring workers to work faster increases labor demand (since workers produce more value per hour) and reduces labor supply (since workers don’t like working faster).  This might be enough to eliminate any labor surplus created by the minimum wage:

However, this does not show that minimum wage laws make the typical worker better off.  It was already legal for employers to offer to pay higher wages in exchange for faster work, so the fact that this didn’t already happen is a strong sign that workers prefer a more leisurely pace to higher wages.  And if product demand is relatively inelastic, working faster actually makes labor demand go down!

2.  Consider two different guest worker programs the U.S. might adopt: (a) anyone on earth can legally work in the U.S.; (b) anyone on earth can legally work in the U.S. as long as they score above the U.S. average on an IQ test.  Both programs make guest workers ineligible to collect government benefits or vote.  Compare the economic effects of (a) and (b).  Which is better for mankind?  Which is better for Americans?

Guest worker program (a) would lead to a large increase in the supply of high-skilled workers and a very large increase in the supply of low-skilled workers.  The net effect on foreign wages would be large and positive.  The net effect on native wages in unclear: higher supply tends to reduce wages, but specialization and trade increases labor demand and increase wages.  Low-skilled native wages would probably fall.  However, the overall effect on native well-being would be positive, because massive immigration would massively help employers, investors, retirees, land-owners, etc.

Guest worker program (b) would lead to a large increase in the supply of high-skilled workers, but little increase in the supply of low-skilled workers.  The net effect on high-skilled foreign wages would be positive, but low-skilled workers wouldn’t benefit much.  The net effect on native wages remains unclear, but low-skilled natives would clearly gain.  The overall effect of native well-being would still be positive due to the effects on employers, investors, retirees, land-owners, etc., but this gain would be much smaller than in (a).

(a) is clearly better for mankind.  (a) is better for Americans, though low-skilled Americans might lose out since there would be a much bigger influx of low-skilled than high-skilled workers.