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?

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

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?)


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

A.                 First-class airplane seats.

B.                 Dessert and appetizers at a restaurant.

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

D.                Charging more for hardback books than paperback books.



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

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?

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

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?


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.

B.                 Rotgut liquor during Prohibition.

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

D.                Why airplane food was better before deregulation.

E.                 Bulldozing "slums."

F.                 Breaking up the Gotti crime family.


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:


Total Time Spent


Chance of

Finding HW

Expected Marginal Benefit of Search
















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.

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

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).

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?


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?


VII.              Watch (or listen to) two commercials. 

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?

B.                 Did the ad try to change your preferences?

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


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?

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?


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.

B.                 Wearing a suit for an interview.

C.                Having a big military parade in Red Square.

D.                Giving away free samples of your product.


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

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

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

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