Prof. Bryan Caplan

Econ 370


HW#4 (please type; diagrams may be drawn by hand)


I.                     "Field trip": the next time you are at the store (or on the web), look at a section of products you've never purchased.

A.                 What is the type of product you looked at? How many varieties were there?


My wife made me look at and help her pick out a set of coasters (the things you put under a glass to keep it from "sweating" on furniture). There were at least 30 different kinds of costars.


B.                 List three of the varieties. Did they clearly differ in quality, or were they merely different varieties?


There was a set with planes on it, a set with castles, and a set with flowers. They seemed to be different varieties, rather than different qualities.


C.                Does the theory of differentiated competition shed any light on the prices of the three varieties you looked at? (Hint: did the varieties seem to serve big markets or small markets?)

The costars were expensive because they served a small market. About $15 for 6 plastic squares.


II.                   Is it price discrimination, or is it quality difference?

A.                 First-class airplane seats.


Quality difference.


B.                 Dessert and appetizers at a restaurant.


Quality difference - remember you are also filling up a restaurant table for more time.


C.                A $500 spoiler on a new sports car.


Price discrimination (probably).


D.                Charging more for hardback books than paperback books.


Definitely price discrimination - otherwise both kinds would be available from the get-go.



A.                 Using supply and demand diagrams, show the impact of rent control on the housing market.


Rent control should be drawn as a price maximum, so there is a shortage of housing (demand exceeds supply).


B.                 Now suppose that quality can adjust to rent control even though the price of housing can't. What happens to the supply curve as quality declines (remember that it is cheaper to supply lower quality housing)? What happens to the demand curve as quality declines?


The supply curve shifts to the right (suppliers are more willing to supply a cheaper quality at a given price); demand shifts to the left (demanders are less willing to buy a cheaper quality at a given price).


C.                Using S&D diagrams, show what the housing market will look like if the decline in quality is sufficient to clear the market.


S&D intersect at the legal maximum.


D.                Puzzle: Why isn't the response of quality to price controls normally sufficient to clear the market? For example, why can't you get rid of the teenage unemployment caused by the minimum wage by working the teenagers harder?


At least in some cases, there seems to be little or no way to change the quality level. You can't make cashiers work faster than the customers wants to order. Also, monitoring may be a problem if you try to work people harder. Any better answers?



IV.               Discuss the relationship between regulation/prohibition and quality in each of the following cases. Is there an important non-regulatory factor in any of these cases?

A.                 Shrinking candy bars during the '70's.


Price controls led firms to cut quality.


B.                 Rotgut liquor during Prohibition.


Making liquor illegal made it difficult to keep quality up with warrantees and reputation.


C.                Why New York City needs a huge number of building inspectors.


Rent control leads landlords to cut quality. The inspectors try to stop landlords from cutting quality as much as they would like.


D.                Why airplane food was better before deregulation.


There was a price minimum for airline tickets, so there were surplus seats on planes. Airlines competed for extra customers by improving the quality of meals and other extras.


E.                 Bulldozing "slums."


This was supposed to help poor people, but it is unclear how reducing the supply of low quality goods is supposed to do that.


F.                 Breaking up the Gotti crime family.


Since organized crime tends to keep quality up in illegal markets, breaking up the Gottis will tend to reduce the quality of narcotics. This may mean that more people die from e.g. adulterated crack.


V.                 You have lost your homework, and need to decide if you should just re-do it, or look around for it. You value your time at $10/hour - that's about 83 cents for 5 minutes. It will take you 1 hour to re-do the homework. Your searching abilities are as follows:


A.                 Fill in the 3rd column of the table. The "expected marginal benefit of search" is just the value of the (complete) homework times the marginal increase in the probability of finding it.


Total Time Spent


Chance of

Finding HW

Expected Marginal Benefit of Search

















B.                 What is your marginal cost of searching for five minutes?


83 cents.


C.                Search theory says you will set the marginal cost of search equal to the expected marginal benefit of search. If this is true, how long will you search for? (Feel free to round to the nearest table entry).


You'll search for 20 minutes. The expected marginal gain of searching for five further minutes ($.50) is less than the marginal cost ($.83).


D.                Suppose you search until the marginal cost of search equals the expected marginal benefit, but you still haven't found your homework. Should you search some more, or give up? Why?


Give up. The fact that you wasted time searching is just a sunk cost. You'd better just re-do the homework and quit wasting your time.


VI.               How much time do you spending "searching for" (selecting) your classes? Have you ever found yourself stuck in a bad class because you did not search enough?


I often picked classes without searching much - sometimes for as little as 5 or 10 minutes. I probably should have searched more, all things considered... but I was lazy. However, if I showed up to the first day of class and hated it, I often dropped.


VII.              Watch (or listen to) two commercials. [I only watched one.]

A.                 Did they alert people to the existence of a product, remind them about a product, provide information about price, or provide information about product features?


I watched a commercial for Magic: the Gathering on Comedy Central. I had heard about the game, but the commercial reminded me about it and told me some more about how the game works and who might like it. The commercial had no price information.


B.                 Did the ad try to change your preferences?


I think the ad mainly tried to appeal to my existing preferences for "thinking games."


C.                Did the regulation of advertising appear to affect the presentation or content of the commercial in any way? Think hard.


Though I thought hard, I did not notice any impact of regulation on the ad. Any commercial with fine print or a guy rapidly uttering things like "no purchase necessary" probably has been, however.


VIII.            Suppose people buy "lightning insurance," which insures them against being struck by lightning. Saving the life of a person struck by lightning costs $1,000,000. The odds of this happening to a given person is 1-in-a-million.

A.                 What is the "actuarially fair premium" for lightning insurance?




B.                 Why must the market premium somewhat exceed the actuarially fair premium?


To pay for overhead, advertising, underwriters, etc.


C.                Suppose there is a group of recreational lightning watchers. Their chance of being struck by lightning is 1-in-a-100. What is their actuarially fair premium?




D.                Suppose 10% of people are lightning watchers, while 90% are not lightning watchers. If the law requires insurers to charge them the same premium, what will the actuarially fair premium be?




E.                 If the premium for lightning insurance exceeds $10, regular people refuse to buy it. What then will be the impact of banning risk-adjusted premiums on the quantity and price of insurance sold?


Then regular people will buy no insurance; 100% of buyers will be lightning watchers, who will then have to pay a premium of $10,000. The impact of regulation is that regular people quit buying insurance, while lightning-watchers pay the same rate as before.


IX.               Present a signaling explanation of each of the following (the signaling explanation does not have to be right - just try to come up with a plausible one). Be sure to specify: (a) What "types" people are trying to distinguish, and (b) Why the different types have different costs of doing the particular kind of signaling.

A.                 Buying wedding rings.


Women are trying to distinguish the serious suitors from the non-serious suitors. A serious suitor has a lower expected cost of providing the ring because it is highly probable that he will actually go through with the marriage (and won't have to buy another ring for someone else next month!)


B.                 Wearing a suit for an interview.


Employers are trying to distinguish the professional people from the non-professional people. Non-professional people find it more unpleasant to conform and dress up, so they are less likely to wear a suit.


C.                Having a big military parade in Red Square.


Countries are trying to distinguish the countries that are willing to fight to get their way from those that won't. Peace-loving, militarily unprepared countries (Luxembourg?) will find it more expensive to put on a believable military "show."


D.                Giving away free samples of your product.


Customers want to distinguish good products from bad. It is cheaper for a good product's maker to give away free samples, because they anticipate that you will buy their product once you find out how much you like it.



A.                 Which class in college has given you the most job-related skills?


Graduate microeconomics I've now taught this class a couple times myself.


B.                 Which class in college has given you the least job-related skills?


Ancient philosophy. Economists don't get to talk about Heraclites very much.


C.                What percent of the first class was "signaling" (as opposed to job-related training)? What percent of the second class was "signaling"?


20%; 100%.


D.                Puzzle: Why don't employees give their employers money-back guarantees?


One big factor is the illiquidity of many workers. While people are rich in human capital, they are often poor in liquid capital and find it hard to borrow more than a small percentage of their true net worth. In other words, few workers could afford to pay back a year's salary if their employer demanded it. Employers realize this, so a money-back guarantee would usually be an empty promise.