Economics 370 Midterm

Prof. Bryan Caplan

Spring, 2004


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 any given year, most firms report that they earned a profit.


T, F, and Explain: This is evidence for the widespread existence of monopoly through superior efficiency.


FALSE. What firms report are accounting profits, not economic profits. Competition only tends to eliminate the latter, not the former. If you do not subtract out the normal market rate of return, you are going to see widespread profits that are not really there.



2. David Friedman ("State Monopoly for Fun and Profit") discusses voluntary efforts to raise the price of crude oil in the 19th century.


T, F, and Explain: Two of the problems the oil cartel faced were cheating and hold-outs.


TRUE. Friedman quotes Rockefeller to exactly this effect on p.40. Cheating was rampant: "the temptation was very great to get a little more oil than they had promised." And hold-outs were also a problem: "any who were not in this association were undertaking to produce all they possibly could."


3. T, F, and Explain: Demsetz's study of the concentration-profits relationships predicts that natural monopolies will not have unusually high profits.


FALSE. A natural monopoly by definition has 100% concentration and 100% market share. Demsetz finds that concentration does not raise profits but market share does. So while Demsetz would not predict extra profits as a result of the high concentration, he definitely would predict extra profits for natural monopolies on account of their high market share.









4. Two firms with different costs competitively bid for a monopoly over the sale of alcohol in Fairfax County.

T, F, and Explain: This will reduce both productive and allocative efficiency compared to free competition.


FALSE. Since there is competitive bidding, the firm with lower costs will out-bid the firm with higher costs, implying no productive efficiency. There will still however be allocative inefficiency since the lower-cost firm will raise price above MC to take advantage of its privileged position.


One clever alternate answer observed that the identity of the most productively efficient firm would change over time, so even though there would be no productive inefficiency initially, it would eventually kick in.


5. Caplan argues that population growth has an important positive externality: it increases R&D.


T, F, and Explain: This effect on efficiency is at least partially off-set by the negative externality that immigrants create by reducing native workers' wages.


FALSE. When native workers' wages fall, their losses are equally and by definition balanced out by the gains to employers and consumers. If a worker's wage falls by $1, there much be someone who is $1 richer as a result. This is known as a "pecuniary externality."


6. T, F, and Explain: Copyrights and patents make it easier to price discriminate, further increasing the incentive to do R&D.


TRUE. Competition makes it harder to price discriminate, because other firms will steal away the customers you're overcharging. With a legal monopoly like a patent, you do not have to worry about this effect. Therefore you can price discriminate more readily, allowing a patent-holder to earn extra profits. This in turn encourages R&D. One good example: Drug companies often price discriminate by charging lower prices in poor countries.




Part 2: Short Answer

(20 points each)

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


1. In class, Caplan argued that there are "infra-marginal externalities" of food production. Briefly explain what he means. Using a supply-and-demand diagram, indicate the effect of a large reduction in the supply of food. In plain English, what does the diagram show?


"Infra-marginal externalities" are externalities that are not relevant at the equilibrium price. In the case of food, if production is very low, there are large external benefits, because starving people are likely to riot and rob. Virtually no one however is going to riot in the modern U.S. just because food gets a little more expensive, however, because at the equilibrium price basically everyone can eat their fill. If there were a large reduction in supply due to a famine, prices would rise, and the social benefits of food production that we now take for granted we disappear.










2. "America could never have achieved its material abundance without the downsizing, restructuring, and re-creation of the economy that comes with the churn." (Cox and Alm, Myths of Rich and Poor)


What is "the churn"? How do Cox and Alm connect it to rising living standards?


"The churn" is a metaphor for the perpetual turbulence in the labor market the Darwinian struggle of firms to survive in the face of constant economic change. People are always figuring out new ways to produce, new things to produce, and responding to changing opportunities. This leads to a lot of job destruction, but as Cox and Alm explain, it simultaneously leads not only to job creation but more importantly to constantly rising productivity and consumer choice. Competition leads weaker firms to go bankrupt and lets stronger firms expand, to the long run benefit of almost everyone. Imagine what the world would look like if government had tried to save the horse-and-buggy industry back in 1900!