Economics 370 Midterm

Prof. Bryan Caplan

Spring, 2003

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.  In a recent issue of Entertainment Weekly, a screenwriter observes that successful "reality shows" (like Joe Millionaire) have far fewer episodes than successful scripted programs (like Friends).  But in both cases, developing a new series requires a large up-front investment.

T, F, and Explain:  This explains why reality shows are cheaper to produce than scripted shows.

FALSE.  Dividing fixed costs over a smaller number of episodes means higher average costs.  The only way that reality shows could be cheaper, then, is if the cost-per-episode  is so much lower than it balances out the effect of dividing the fixed costs over a smaller number of episodes.

2.  "The reason that a monopolistic grant to a business does not always raise prices, is that businesses can always expand or contract their production at will.  Licensing of grocers does not necessarily reduce total supply, because it does not preclude the indefinite enlargement of licensed grocery firms, which can take up the slack created by the exclusion of would-be competitors." (Rothbard, Power and Market)

T, F, and Explain: Rothbard's argument works only if licenses are given away for free.

TRUE.  If firms have to pay for licenses, their average costs rise.  Therefore equilibrium price must go up too, leading consumers to buy a smaller quantity.

3.  Suppose a government regulator says the following:

"Rate-of-return regulation gives firms an incentive to raise their costs.  From now on, instead of regulating the rate of profit, we will just set a maximum price.  This leaves firms with every incentive to cut costs, because if they figure out a way to save a dollar, they get to keep the dollar."

T, F, and Explain:  This regulatory change solves one problem but creates another that is about as serious.

TRUE.  Firms will no longer have an incentive to raise costs, but they will instead have an incentive to cut quality.  Since lower quality costs less, firms can make more profit by charging the official price for sub-par goods.

4.  Suppose that the government awards a monopoly privilege to produce wheat to whichever firm lobbies hardest.  An economist working for the government suggests that the government pass a second law forbidding the sole licensed wheat-grower to price discriminate.

T, F, and Explain:  This ban on price discrimination will hurt allocative efficiency without having any offsetting efficiency benefit.

FALSE.  A monopoly who practices price discrimination earns higher profits than a monopoly than can only charge a single price.  If firms competitively lobby for the privilege - so that total lobbying costs equal monopoly profits - lobbying costs will be higher if they are allowed to price discriminate!  The ban on price discrimination does indeed hurt allocative efficiency, but it decreases the deadweight costs of lobbying.

5.  In order to receive satellite radio, a consumer has to spend a couple hundred dollars for a new radio, then pay a monthly subscription fee.  This radio is only useful if the satellite company does not go bankrupt.

T, F, and Explain:  The market for satellite radio may suffer from a coordination problem.

TRUE.  The fewer people subscribe, the more likely the satellite company is to go bankrupt, making the upfront investment in the new radio worthless.  Thus, if a lot of people subscribe, you may want to subscribe too; if few others subscribe, you may not want to either.  The satellite provider could solve this coordination problem by subsidizing the radios and raising the subscription fee.  That way, consumers would not need to worry whether the provider will survive.

6.  Imagine that the use of narcotics is illegal, but their production and sale is not.  Narcotics are produced with a fixed cost and constant MC.

T, F, and Explain:  Increased legal enforcement will raise the price of narcotics.

TRUE.  Punishing users reduces demand; under normal conditions, it would reduce the price of narcotics.  But if they are produced with a fixed cost and constant MC, the AC curve is always falling.  Using the standard model of differentiated competition, then, as demand goes down, equilibrium price goes up.

Part 2: Short Answer

(20 points each)

In 4-6 sentences, answer both of the following questions.

1.  During the "Age of Exploration," monarchs sometimes gave companies that discovered new trading routes a monopoly on trade in the territory they discovered.  For example, if a firm discovered spices on Fiji, the king might forbid other firms from trading with Fiji.  Provide an efficiency rationale for such policies.  How convincing is the rationale?

You could think of monopoly trading routes as analogous to patents.  With a patent, you award inventors a monopoly to create an incentive to invent.  Similarly, giving discoverers a monopoly on what they discover creates an incentive to discover.  Otherwise, a firm might spend a lot of money to find a new spice source, only to find that their competitors quickly free ride off their investment.  Like a patent, the value of the monopoly depends on the value of the discovery; getting a trading monopoly on a barren island isn't worth much.  Overall, this rationale is at least somewhat convincing.  It depends on how effective "non-patent" incentives for exploration are.

2.  "The least plausible features in our composite description of organized crime are the alleged national and even international scale of operations and the alleged monopoly profits." (Posner, Economic Analysis of Law)

Explain Posner's arguments on these points.  Is he right?

Posner essentially argues that there are severe diseconomies of scale.  For one thing, organized crime focuses on wholesale and retail distribution, industries that normally have limited scale economies.  Furthermore, "the covert form that criminal enterprises are constrained to assume" to reduce the risk of prosecution push further toward decentralization.  Given this decentralization, then, earning monopoly profits will be difficult; collusion is hard for a small number of firms, but impossible for a large number.

Posner's arguments seem fairly sensible.  But at least in drugs, manufacturing - which normally has a bigger minimum efficient scale -  is also a major activity, along with wholesale and retail.  Big firms may also be more effective at reducing the probability and severity of punishment.  A firm big enough to bribe all of the judges in Chicago will find it easier to recruit workers than a small-time operation where the boss only knows a couple of judges.