Prof. Bryan Caplan

Econ 370


HW#1 Answer Key


I.                     Use supply and demand diagrams to analyze the effects of the UPS strike on:

A.                 The market for package shipping


Supply decreases.


B.                 The market for college textbooks (which have to be shipped)


Supply decreases.


C.                The market for truck drivers


Demand increases.


D.                Analysis: Do all three of your answers make sense to you?  Are any of your predictions wrong or over-simplified?  Explain.


Many firms rationed their services (refusing to take new customers, etc.) instead of raising their prices.  Several people suggested, reasonably, that this is due to the short-term nature of the supply disturbance.


II.                   In his Philosophical Considerations, the anarcho-communist Bakunin writes that:


What the economists call equalized supply and demand does not constitute real equality between those who offer their sale and those who purchase it...What happens in the market is a meeting between a drive for lucre and starvation, between master and slave.  Juridically they are both equal; but economically the worker is the serf of the capitalist, even before the market transaction has been concluded whereby the worker sells his person and his liberty for a given time.  The worker is in the position of a serf because this terrible threat of starvation which daily hangs over his head and over his family, will force him to accept any conditions imposed by the gainful calculations of the capitalist, the industrialist, the employer.


The result of the interaction of supply and demand in the labor market,

then, is that:


Since the worker finds himself in a state of poverty, the worker is compelled to sell his labor for almost nothing, and because he sells that product for almost nothing, he sinks into ever greater poverty.


A.                 Try to graphically represent the conditions that Bakunin describes in the first paragraph using supply and demand diagrams.  Pay particular attention to the shape of the labor supply curve -- what would it look like if workers are "forced to accept any conditions"?


The supply curve should be drawn vertically.  If you will "accept any conditions," then presumably your supply decision is independent of the price.  There is no assumption made about the labor demand curve, other than that it has its normal negative slope.


Several people drew horizontal slopes for the labor supply curve.  So long as the labor supply curve is horizontal at the subsistence wage, this makes Bakunin's conclusion true; but that wasn't his argument!  He didn't say that there is an unlimited supply of workers (an odd premise, indeed); he said that existing workers will take whatever is offered.


A couple people mentioned that Bakunin is assuming a monopoly (or a "monopsony" - a technical term for a situation where there is only 1 buyer).  This is exactly right.  If you are the only buyer, you shouldn't draw a demand curve at all.  The monopsonist just picks whatever point on the supply curve he wants to.  Bakunin's conclusion, therefore, makes no sense at all for an economy with many employers, but it might be an excellent characterization of the condition of workers in a totalitarian state.


B.                 Accepting the assumptions in the first paragraph as correct, does the conclusion about the wage rate (the price of labor) given in the second paragraph follow?  What happens if the demand for labor increases?


If you look at the intersection of S&D, there is nothing to indicate that they intersect at the subsistence level.  (If I had told you that it were the market for Rembrandt paintings, this would have been more obvious.  Rembrandt might love painting so much that he paints in all of his free time, but this doesn't mean he won't be paid millions per painting if demand is great enough.) Similarly, a shift up in demand raises wages without increasing the quantity of labor sold.


C.                Real wages have risen tremendously since the 19th century during which Bakunin wrote.  Comment on the relevance of your answer to (2) for this long-run historical trend.


The answer I was looking for is that the labor demand curve has been continuously increasing at a high rate since Bakunin's time.  His assumption about labor supply strikes me as quite reasonable - people in poor countries don't quit working even though it pays very little.  Bakunin just didn't understand supply and demand curves.  At a very low wage, there is excess demand for labor, bidding the wage up.


Some people gave answers that high school history teachers like, but which are very poor economics, such as that workers get paid more now because of unions, minimum wages, and labor regulations.  (If you wonder why these are poor explanations, try working it out on your diagram.  Minimum wages or unions setting above-market wages create unemployment; labor regulations, insofar as they prohibit the most profitable use of labor, shift the labor demand curve down).


III.                  GM, Ford, and Chrystler compete in the car market.  GM’s marginal cost of producing a car is $8000; Ford’s is $10,000; Chrystler’s is $11,000.  The market works like we discussed in class: the low-bidder gets the whole market, and a tie splits the market evenly.

A.                 What price will result from competition between these firms? 


$9999 - GM just undercuts Ford's marginal cost.


B.                 What are the profits per car sold for each firm?  Does any firm earn positive profits?


GM earns $1999 per car sold, and sells a positive quantity.  Therefore it's profits are positive.  Ford and Chrysler would both lose money on each car produced if they did produce any (which they won't!).


C.                How many firms actually produce cars?


1 - GM.


D.                The government argues that GM is a “monopoly” and puts a $2000/car tax on GM cars as punishment.  What happens to the car market now?  Who benefits from this?


Now GM and Ford split the market, and the price is $10,000.  GM loses $1999 in profit per car; Ford still makes no profit; consumers pay $1 more per car.


IV.               Draw your personal cost curves for the following tasks.  Describe what the fixed cost is and what the marginal cost is, and how these affect your decisions.

A.                 Taking out the trash.


The fixed cost of taking out the trash is the trouble of schlepping to the trash bin.  The marginal cost is the increasing difficulty (and odor) of a larger and larger quantity of trash.  My AC curve reaches a minimum at about 1 trip per 3 days.  (My wife's curve, however, reaches a minimum at about 1 trip per day).


B.                 Commuting to campus.


The fixed cost is the drive over; the marginal cost is the (increasing) unpleasantness of being at work for hour after hour.  I reach a minimum at 1 commute per day.


C.                Deciding how many classes to take.


I don't take classes anymore, but I could figure the cost-minimizing way to teach classes.  I could teach 4 in one semester, or 2 per semester.  Then the fixed cost of teaching is needing to be in town every week; the marginal cost is the (increasing) unpleasantness of teaching and preparing for each class.  I reach a minimum at 2 per semester.


V.                 Provide one example (historical or contemporary) of each of the following.  Briefly (2-3 sentences) explain who exercised the monopoly privilege and who (on net) profited from it.  Your example can come from class, the readings, or your own knowledge.

A.                 A monopoly exercised by the government itself.


Most people said the post office, which is a fine example.  The government exercises the privilege; although considering the fact that the post office often loses money, probably the real beneficiaries are postal employees.


B.        A monopoly auctioned off by the government to private suppliers.


Most people mentioned Queen Elizabeth here; but liquor licenses would have been a fine example too.  (What matters isn't whether or not you literally hold on auction, but whether the government makes sure it gets the full value of the privilege).  With a liquor license, the holder of the license is protected from unlicensed competition, but the government gets the revenue from the sale of the license.


C.        A monopoly given by the government to private suppliers.


Agricultural cartels are a good example.  Farmers received protection from competition, and got the monopoly profits.


VI.               The Queen holds on auction on the monopoly right to produce and sell tea.  There are two available producers of tea.  The demand curve for tea, and the costs of the two producers (Lancaster and York), are given in this table:



per ton

Quantity (tons)

Total Revenue

Total Cost of Lancaster

Total Cost of York

Total Profit of


Total Profit

of York

































































A.        If Lancaster received the monopoly privilege, what price and output level would he set?  What would his (gross) monopoly profits be?


Price would be £800; quantity 3000; profits £1,200,000.


B.                 If York received the monopoly privilege, what would his price, output, and (gross) monopoly profits be?


Price would be £800; quantity 3000; profits £900,000.


C.                If the Queen auctioned off the monopoly privilege to Lancaster and York, who would win the auction?  How much would the winner pay?


Lancaster would win and pay £900,001 - just enough to beat York.


D.                Are there any losses to productive efficiency from this grant of privilege?  To allocative efficiency?  Why?


There are only losses to allocative efficiency; bidding ensures that the productively efficient firm wins.


E.                 Suppose the Queen, sensitive to the charge that she is enriching herself with these auctions, randomly selects the recipient of the grant (by making Lancaster and York publicly play Rock, Paper, Scissors, for example).  How are the deadweight losses of monopoly likely to be affected?


The deadweight costs will be greater if York wins, because York is the less efficient producer.


F.                 Parliament strips the Queen of the right to give monopolies, and declares that henceforth monopolies will be awarded to whichever firm gets the most votes from the members of Parliament.  Lancaster and York compete for votes by paying for political advertising for their supporters, hiring lawyers, and so on.  Who, if anyone, now benefits - on net - from the distribution of monopoly grants?


Probably no one benefits.  Politicians now have to pay more to win elections.  Lobbyists just get paid enough to make them switch from their non-lobbying occupation.


VII.              In each of the following cases: (a) Describe the resources Transferred; (b) describe the Deadweight Costs; (c) suggest how the deadweight costs might be avoided.  Try to be as comprehensive as possible - and make sure you remember opportunity costs!

A.                 The car theft "industry."


Transfer: the value of the "hot" car or the sale of parts to the "chop shop." 

Deadweight costs: security systems, the thief's time (he could have been working at a real job), extra resources spent to park and garage the car.  Also: maybe someone won't buy a car because they think it will be stolen anyway (or because they are willing to pay the price of the car, but not the price of the car plus the price of theft insurance, so they don't buy one).

A way to avoid the deadweight costs: Selling car thieves as slaves might do it.  Big deterrent, and the resources taken from the thieves would just be a transfer.


B.                 Prohibiting the copying of an article without the express written permission of (and payment to) the publisher.


Transfer: the royalties paid to the copyright owner. 

Deadweight costs: time and resources to get permission, articles not copied because they are valued less than the royalty, effort spent by students who have to copy everything "on reserve."

A way to avoid the deadweight costs: You could get rid of copyright laws.  In the long-run, of course, this would greatly reduce the incentive to publish or write anything.  Alternately, universities could make a flat payment to publishers for unlimited copying privileges.


C.                Putting out free tables and chairs in the Johnson Center cafeteria.


Transfer: Free tables for students and faculty. 

Deadweight costs: time and energy spent searching for a "free" table.

A way to avoid the deadweight costs:


D.                The Civil War (including the abolition of slavery).


Transfer: The slave-owners' property rights in slaves were transferred to the slaves; also, any looting by Northern troops would be a transfer. 

Deadweight costs: not just the dead soldiers and destroyed property - but also the lost time of the soldiers on both sides (they could have had a job or relaxed instead of soldiering).

A way to avoid the deadweight costs: You could have tried compensated abolition of slavery.  Fun fact: the military budgets of both sides were much more than the market value of all U.S. slaves.  Britain abolished slavery in its colonies with compensation in the 1840's.  Critics of the compensation thought this unfair - one said "I'd think it was the slaves who should be compensated."


VIII.            Wholesale clubs typically charge a membership fee to shop with them, but have much lower prices.  Suppose your local grocery store prices 10% above marginal cost.  Explain why it would be more efficient for them to charge you a membership fee, and reduce their prices.  What is the biggest annual membership fee you would pay to your grocery store if they reduced prices by 5%?  By 10%?  Explain why you should be willing to pay more than (your current grocery bill*% discount).


If they charged a membership fee and reduced their prices, there would be fewer products with P>MC, so I would buy additional products that I valued above the cost of production.  I would pay roughly $80 for a 5% discount and $200 for a 10% discount.  Figuring I currently spend about $100/month, or $1200 per year, it might naively seem like a 5% discount would be worth $60, and a 10% discount $120.  But if the price fell, I would buy more products, and get some surplus from those new products, so the discount is worth more in both cases.


IX.               Try to provide examples of each of the following.  If you can't produce an example, explain why.

A.                 A grant of monopoly privilege with losses to allocative efficiency, but no loss in productive efficiency. 


A grant of privilege to the most efficient producer.


B.                 A grant of monopoly privilege with losses to productive efficiency, but no losses in allocative efficiency. 


Suppose you impose a tariff on cheaply-produced foreign wheat, but don't restrict domestic wheat output.  Domestic producers still have to price at marginal cost, so there is no allocative inefficiency; but since their costs are higher than foreign competitors', there is productive inefficiency.  Alternate example: Suppose there are three producers.  One can produce cheese at $1/lb.; the other 2 can produce at $2/lb.  If you legally ban the first firm from competing, but don't regulate the other two firms, they bid price down to their marginal cost of $2.


C.                A grant of monopoly privilege with losses to neither productive nor allocative efficiency.


Suppose you impose a tariff on foreign wheat - which is produced as efficiently at home as abroad - and still don't restrict domestic wheat output.  Domestic producers still have to price at marginal cost, so there is no allocative inefficiency; and since their costs are the same as foreign competitors', there is no productive inefficiency.  Alternate example: Suppose there are three producers.  All can produce cheese at $1/lb.  If you legally ban the first firm from competing, but don't regulate the other two firms, they still bid price down to $1.  The ban on the first firm did nothing for them!


D.                A grant of monopoly privilege worth more than the total consumer surplus under free competition.


Impossible - the monopoly profits come from reducing consumer surplus.  One student said that this was possible if the monopolist had lower costs than firms under free competition.  This was a nice try, but how could an industry with free competition fail to produce at minimum cost to begin with?


E.                 A worthless grant of monopoly privilege (i.e., one where an auction for the privilege would raise no revenue). 


Easy - the monopoly on Halloween masks with my face on them.  No one wants them, so what good is a monopoly on them?


X.                 Suppose that Congress plans to award a monopoly privilege worth $10,000,000 to whichever firm gets it.  Every firm that retains a lobbying team has an equal chance of winning the privilege.  It costs $100,000 to retain a lobbying team.

A.                 How many firms have to lobby in order to make hiring a lobbying team an even bet (expected profit=0)?




B.                 What does this lobbying activity do to the net monopoly profit earned by the winner?  To the net profits given to the entire industry?


The winner's net monopoly profits: 9,900,000.  Net industry profits: 0.


C.                What if firms pay a bribe (or buy a lottery ticket) instead?  Who, if anyone, now on net gets a monopoly profit?


Congress (for a lottery ticket), or the bribe recipient (for a bribe).   You could also have said that no one benefits because the opportunity for bribes would just make politicians compete more fiercely in elections.


XI.               Analyze ONE of the following grants of monopoly privilege discussed in the readings.  In 1 page or less, explain: (a) What kind of competition the privilege kept out, and how; (b) The gross monopoly profits, and who got them; (c)  The deadweight losses of monopoly (allocative, productive, and "lobbying").

A.                 The NRA

B.                 Medical licensing

C.                The CAB

D.                Immigration restrictions

E.        The Post Office


No one discussed the NRA, so I'll do it.  (a)  The NRA tried to ban or restrict price competition from everyone within the industry; it mainly worked by political pressure, not punishment or fines (and thus did not work very well!).  (b)  The gross monopoly profits were probably very limited, but in firms where the NRA raised prices, the firms got them (so did well-organized or unionized workers in affected industries, who demanded their "cut.")  (c)  Allocative losses: just because prices were raised above MC.  Productive losses: More efficient firms were pressured against expanding output.  Lobbying losses:  Firms, regulators, and code-writers spent a fair amount of effort trying to pass the NRA and make it work.  This is probably best-viewed as a lobbying cost.