Economics 370 Midterm

Prof. Bryan Caplan

Spring, 2005

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. Suppose there are three firms able to produce chocolate chips. Firm 1 has a MC=$.50/bag; Firm 2's MC=$.60/bag; Firm 3's MC=$1.00/bag. There are no fixed costs.


T, F, and Explain: Competition drives price down to $.70, the AC (.50+$.60+$1.00)/3 of the three firms.


FALSE. The lowest-cost firm will set its price just below the MC of the second-lowest-cost firm. That implies a price of $.59/bag.




2. "Ironically, the long-run exploitative possibilities of the protective tariff are far less than those that arise from other forms of monopoly grant. For only firms within an area are protected; yet anyone is permitted to establish a firm there even foreigners. As a result, other firms, from within and without the area, will flock into the protected industry and the protected area, until finally the monopoly gain disappears..." (Rothbard, Power and Market)


T, F, and Explain: Rothbard is saying that at least in this case, rent-seeking/lobbying leads to full dissipation of monopoly profits.


FALSE. Rothbard is not talking about rent-seeking/lobbying at all. Rather, he is saying that new entrants will take advantage of the loophole in the protective tariff to enter. Eventually this new entry eliminates the monopoly gains for the protected industry.




3. Suppose car manufacturers want to work out an agreement to reduce air pollution to help the environment.


T, F, and Explain: The "hold-out problem" makes their agreement more likely to succeed, but "cheating" makes it less likely to succeed.


FALSE. Both the hold-out and cheating problems make this anti-pollution agreement less likely to succeed. The anti-pollution agreement is essentially just collusion albeit collusion with an altruistic goal. Firms that don't sign the agreement or sign and then cheat can make cars at a lower price and undercut the competition.



4. "Supporters of laws requiring motorcyclists to wear helmets argue that injuries from accidents impose a negative externality on insurers or state hospitals." (David Friedman, Hidden Order)

T, F, and Explain: Friedman argues that helmet laws violate individual rights.

FALSE. Friedman talks about efficiency, not individual rights. The efficiency problem with helmet laws, he argues, is that the net externality of wearing helmets could easily be negative. "Helmets eliminate some serious injuries, but they also convert some accidents from lethal to almost lethal. Intensive care is more expensive than a funeral..." Friedman also adds that helmets may increase the number of accidents by encouraging more risk-taking behavior.


5. Rich societies generally have high average levels of education.


T, F, and Explain: This confirms that education has positive externalities.


FALSE. Rich societies usually have more of all productive inputs more machines, more energy, and more educated workers. This hardly shows that any of these things have positive externalities. To demonstrate the existence of positive externalities, you have to show that there are benefits of education the student does not capture.


6. T, F, and Explain: Caplan argues that doubling the size of the population doubles R&D.


FALSE. Caplan argues that doubling the size of the population MORE than doubles R&D. As he explained in lecture, unifying two identical, isolated societies would double the number of inventors. But each inventor would have a bigger market for his ideas, so R&D increases more than proportionally.









Part 2: Short Answer

(20 points each)

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


1. Suppose two firms have the same MC but one firm has higher fixed costs. Use a diagram to show the effect of potential competition on the market price. Explain the logic of your diagram.


The firm with the lower fixed costs produces just below the INTERSECTION of industry demand curve and the competitors' AC curve. Notice the shape of the AC curves: Since they have the same MC, the firms' AC curves get closer and closer as Q goes up.

















2. Suppose juries on antitrust cases were made up entirely of economists. Describe the probable effect on antitrust enforcement. How would businesses be likely to respond to this new legal climate?


Due to the vagueness of antitrust laws, there is a lot of room for juries to tilt the results. If economists were doing the tilting, they would put more emphasis on efficiency and less on protecting small business. Cases involving franchising, predation, and price discrimination would probably get a much less sympathetic hearing. In contrast, most economists would probably still take cases involving collusion and price-fixing seriously. Business would respond to the new legal climate by doing more of what the law now de facto punishes less more franchising, more price-cutting, more price discrimination.