Economics 321 Midterm

Prof. Bryan Caplan Fall, 2014

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 q F, and Explain: When wages rise, individual workers always respond by working more hours.

FALSE. At the individual level, workers' tendency to work more as the wage rises (the substitution effect) may be overpowered by workers' tendency to consume more leisure as the wage rises (the income effect). Some workers do work more when wages rises, but others work less.

2.         "Productivity growth in one sector can very easily reduce employment in that sector."

(Krugman, The Accidental Theorist)

T, F, and Explain: The good news, Krugman argues, is that workers in declining sectors can easily find better-paying jobs in expanding sectors.

FALSE. Krugman only argues that productivity growth is good for workers in general. He does not say that workers in declining sectors automatically share in this rising prosperity. They may find themselves stuck in long-term unemployment, or end up settling for a new job far inferior to their old job.

3.         Sometimes unions bargain for safer workplaces rather than higher wages.

T, F, and Explain: This will not disemploy workers, because increasing worker safety has clear benefits for employers as well as workers.

FALSE. If increased safety really benefited both employers and workers, employers would already have adopted it. Any additional safety is a costly benefit, leading to lower Labor Demand and higher Labor Supply. With perfectly flexible wages, this simply leads to lower wages without causing unemployment. In the real world, however, there is likely to be some nominal rigidity, so the union's demand will disemploy some workers in the short-run.

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4.         In the real world, immigration increases Aggregate Labor Demand along with Aggregate Labor Supply.

T, F, and Explain: The reason is that central banks adjust the money supply to keep the price level from falling.

FALSE. Aggregate Labor Demand depends on MVP=MPP*P - workers' average MPP times the price level. In the real world, immigration raises MPP via comparative advantage: Workers with different skills specialize and trade, increasing productivity per worker. When central banks stabilize P, Aggregate Labor Demand rises because MPP rises, not because P stays the same.

5.         Female college students are more likely to complete their degrees, but less likely to actually work after graduation.

T, F, and Explain: Taken together, these facts do not imply that women have a higher return to education than men.

TRUE. Women's higher degree completion rate gives them a higher expected return to education; their educational investments are more likely to lead to a diploma. But their lower labor force participation rate gives them a lower expected return to education, because they are less likely to "cash in" on their diplomas in the job market. We cannot know the NET effect of these two opposing factors on returns without more empirical details.

6.         After graduation, electrical engineering majors make about 75% more than education majors.

T, F, and Explain: If the typical education major switched to electrical engineering, his expected earnings would rise by less than 75 0/0.

TRUE. Engineering and education majors differ long before they start college. Most obviously, engineers tend to be much stronger students, especially in math and science. The typical education major who switched to engineering would be near the bottom of his classes, and therefore likely to earn far less than the average engineer (even assuming he could graduate).

Part 2: Short Answer

(20 points each)

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

1.    According to Bastiat:

[l)f the secret wishes of each producer were realized, the world would speedily retrogress toward barbarism. The sail would take the place of steam, the oar would replace the sail, and it in turn would have to yield to the wagon... (Economic Sophisms)

Carefully diagram Bastiat's argument using an Aggregate Labor Market diagram. Is he right? Why or why not?

Bastiat is merely saying that if overall labor productivity sharply fell, this would be an economic disaster. From an Aggregate Labor Market perspective, this means that ALD falls. He's exactly right. (Many students talked about individual occupations rather than Aggregate Labor Markets, and pointed out that Bastiat's argument hinges on product demand elasticity. Quite right, but the question asked about the Aggregate Labor Market!)

2.    Obamacare fines firms that fail to provide health insurance for their full-time workers. What are the expected negative side effects of this employer mandate? How would you expect these side effects to differ if inflation had been hiqher since Obamacare's passage?

The mandated benefit reduces labor demand (employers are less eager to hire if they have to provide health insurance) and increases labor supply (workers are more eager to work if they get health insurance). The expected negative side effects: Since wages are somewhat nominally rigid, real wages will fall AND unemployment will rise. You should also expect a switch to parttime workers. If inflation had been higher, this would have made nominal rigidity less relevant, leading to larger declines in real wages but less unemployment.