Economics 321 Midterm

Prof. Bryan Caplan

Fall, 2013

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:  Bastiat (Economic Sophisms) argues that reducing labor productivity in any occupation makes everyone poorer.

FALSE.  Bastiat repeatedly explains that reducing labor productivity in one occupation makes the people in that occupation better off at the expense of the rest of society: “In so far as we are producers, it must be admitted, each of us has hopes that are antisocial. Are we vineyardists? We should be little displeased if all the vines in the world save ours were blighted by frost: this is the theory of scarcity. Are we the owners of ironworks? We want no other iron to be on the market but our own, whatever may be the public need for it, precisely because this need, keenly felt and incompletely satisfied, brings us a high price...”

2. Suppose a country’s nominal maximum wage in 2013 is \$10/hr, and there is 5% inflation per year.  The market-clearing real wage - \$9/hr in 2013 dollars - will not change until 2020.

T, F, and Explain:  After two years, the labor shortage will have turned into a labor surplus.

FALSE.  A MAXIMUM wage will NEVER cause a labor surplus.  And since this maximum wage starts below the market-clearing real wage, it will not initially even cause a labor shortage.  Every year, however, inflation makes the real maximum wage fall.  This will eventually cause a labor shortage, but after two years, there will still be no effect because inflation-adjusted maximum wage is only \$10/1.052=\$9.07, which exceeds the market-clearing wage of \$9.00.

3. T, F, and Explain:  The “nominal wage fairness” theory of unemployment can explain short-term unemployment but not long-term unemployment, because employers can easily adjust nominal wages for new workers.

FALSE.  The “nominal wage fairness” theory CAN explain long-term unemployment.  New workers may initially be content with whatever wages they receive.  Eventually, however, they will resent the fact that they are paid less than the original workers to do the very same job, hurting morale.  Employers who anticipate this reaction will refrain from cutting wages even for new hires.

4.  T, F, and Explain: According to human capital theory, firms have no incentive to train workers’ general skills.

FALSE.  While workers who improve their general skills can easily bargain for a raise, firms’ obvious response is to pay them a below-market wage – or even a zero wage – during their training period.  Internships are an excellent example.  (If training builds worker loyalty, the below-market wage may not even be necessary).

5. Suppose the government suddenly requires employers to provide their workers with free health care, and nominal wages do not adjust.

T, F, and Explain:  Unemployed workers have an incentive to acquire additional education.

TRUE.  When the mandate goes into effect, the opportunity cost of education (foregone wages plus benefits) goes UP for the lucky workers who earn the same income plus health insurance.  But the opportunity cost of education goes DOWN for the unlucky unemployed workers, because now they no longer have any wages to forego.

6.  Suppose better nutrition increases all workers’ IQ, but not their Conscientiousness.

T, F, and Explain: Average wages will rise; total hours of work will stay the same.

TRUE.  Since the question specifies ALL workers, we should analyze this as an Aggregate Labor Market.  In such markets, higher IQ means higher worker productivity, so ALD goes up.  However, our default assumption in such markets is that ALS is vertical; and since Conscientiousness remains unchanged, there is no reason for ALS to shift.  When ALD goes up and ALS is vertical and unchanged, average wages rise and total hours of work stay the same.

(20 points each)

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

1.  Using everything you’ve learned, how would the labor market change if there were no medical licensing laws?  Discuss the effect on both health care workers and other workers.

Getting rid of medical licensing laws increases the supply of medical workers, and decreases the supply of non-medical workers as they move into the medical field.  So wages of medical workers go down, and wages of non-medical workers go up.  If medical quality fell, the overall social effect could be negative.  But market forces have many ways to maintain quality: reputation (including user reviews), warrantees, and lawsuits.  So not only will non-medical workers enjoy higher wages; their money will buy more because they can pay less for health care of similar quality.

2.  What argument in Caplan’s “Why Should We Restrict Immigration?” can be most easily improved?  Carefully explain how you would improve the argument.

[Students offered several good answers.  Here are a few of the best.]

Caplan argues that the quality of the electorate could be maintained by denying immigrants the right to vote.  But it would be easier and less controversial if the U.S. simply adopted an annual test of political knowledge, with cash prizes for good scores.  Such  a test would give immigrants (like everyone else) an incentive to learn about politics AND retain their knowledge.

Caplan argues that immigrants could pay admission fees or surtaxes to compensate low-skilled Americans who lose out from increased labor market competition.  But since immigration has a large effect on real estate prices, it might be better to simply use extra property tax revenues for compensation instead.