Economics 370 Midterm

Prof. Bryan Caplan

Spring, 2006


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 the government requires all firms to pay a flat $1000/year license fee.


T, F, and Explain: Because the market price will rise, the number of firms that "fit" in the market could either go up or down.


FALSE. The license raises firms' average costs, but does not shift demand. Firms will leave the industry until price rises to equal the new, higher, minimum AC.

2. "On August 19, just before midnight, Roosevelt signed the codes for oil, steel, and lumber. But there were still two major industries to go: automobiles and coal. The problem in Detroit was Henry Ford. Suspicious and independent as ever, Ford had always stayed out of the National Automobile Chamber of Commerce; and he showed no greater disposition to join the other companies in working out an NRA code. Fearing that Ford's refusal would give him competitive advantages, the rest of the industry stalled." (Schlesinger, The Coming of the New Deal)

T, F, and Explain: As this example indicates, one problem with collusion is disagreement about the "division of the spoils."


FALSE. This is an example of the hold-out problem. Ford was not bargaining for an especially good deal from the NACC; he was refusing to join at all.


3. Suppose large firms are better at lobbying than small firms.


T, F, and Explain: This would lead to a positive correlation between concentration and profits.


TRUE. Large firms are more likely to be found in concentration industries. If large firms were better at lobbying than small firms, then, firms in concentrated industries would be more likely to be protected by the government from competition, leading to a positive correlation.


(Large firms are also more likely to be market leaders. So assuming large firms are better at lobbying than small firms, it is ALSO true that there would be a positive correlation between market share and profits. I gave substantial partial credit for this answer).


4. T, F, and Explain: Monopoly problems and positive externalities problems offset each other.


FALSE. Monopoly problems and negative externalities problems offset each other, because the former leads to inefficiently low output and the latter leads to inefficiently high output. Monopoly problems and positive externalities amplify each other, because both lead to inefficiently low output.


5. T, F, and Explain: It is more efficient for a restaurant owner to set up a non-smoking section than it is for the owner to entirely disallow smoking in his restaurant.


FALSE. It depends on the number of non-smokers and smokers, and their respective willingness to pay for the kind of air they want to breathe. If there are lots of rich non-smokers who hate the smell of smoke, and a few poor smokers who only like smoking a little bit, a restaurant owner would want to ban smoking entirely. On the other hand, if the numbers are more even and/or smokers are more willing to pay to smoke than non-smokers are to pay to stop them, smoking sections will be a more efficient approach.


6. Suppose there were no patents for drugs.


T, F, and Explain: There would be little effect on R&D because due to the high fixed costs and low marginal costs of producing a new drug the pharmaceutical industry is naturally monopolistic.


FALSE. Only the innovator has high fixed costs and low marginal costs; imitators have low fixed costs and low marginal costs. So without patents, the imitators would drive price down very low, making it difficult for innovators to recoup their R&D costs.


Part 2: Short Answer

(20 points each)

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


1. Suppose the major television networks write a contract with each other, in which they agree to produce less violent programming. Why would economists doubt that programming will actually become less violent? Explain in detail.


This is open collusion to reduce the supply of violent programming, and will suffer from all the usual problems. Most obviously, the anti-violence contract will provoke new entry from other stations. But it will also lead to: (a) cheating each firm will try to sneak in more violence to steal viewers; (b) hold-outs some firms will refuse to sign; (c) division of spoils firms will argue about who cuts back what; (d) quality competition even if firms keep the agreement, they will try to improve product quality along other dimensions (for example, hiring better writers).


2. What effect does antitrust have on innovation? (Hint: Think about "leapfrog" competition). Use Cox and Alm to support your argument.


Cox and Alm argue that a lot of progress stems from innovative firms putting existing firms out of business ("churn"). But given the existence of antitrust laws, an innovative firm has to be careful about doing this. If its new technology or methods drive all its competitors into bankruptcy, the innovator is likely to be sued and/or prosecuted by the government. The result: Firms have an incentive to "pull their punches" to slow down the wheels of progress enough to avoid legal attention.