Economics 370 Midterm

Prof. Bryan Caplan

Spring, 2002

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.

1.  Two equally efficient airlines, American and United, fly between New York and Los Angeles.  But only one airline, American, flies between New York and Buffalo.  The price of a New York-Los Angeles ticket is \$400.  The price for the much shorter New York-Buffalo route is also \$400.  A Congressman from Buffalo points out that the MC of the Buffalo flight is cheaper, and demand for Buffalo tickets is lower, and concludes that American does not face potential competition.

T, F, and Explain:  The Congressman is incorrect.

TRUE.  If there are some fixed costs, leading to U-shaped cost curves, this is precisely what you should expect.  Potential competition only brings P=AC, not P=MC.  With lower demand for the NY-Buffalo route, American has to charge a higher price to each customer to cover its fixed costs; demand intersects the AC curve before it reaches its minimum.

2.  T, F, and Explain: If patent-holders can price discriminate, this will reduce both allocative inefficiency and the total amount of R&D.

FALSE.  Price discrimination reduces allocative inefficiency, as it always does.  But price discrimination also raises the total amount of monopoly profits a patent-holder can earn; they capture more of the area under the demand curve.  These extra monopoly profits in turn induce more spending on R&D.

3.  Suppose the government imposes rate-of-return regulation on cable tv.

T, F, and Explain:  This will probably increase allocative efficiency at first, but gradually hurt productive efficiency.

TRUE.  At first, regulation will probably push price down closer to MC, raising allocative efficiency.  It is too suspicious if your costs immediately increase after price regulation is imposed.  But rate-of-return regulation reduces the incentive to figure out ways to cuts costs, which gradually hurts productive efficiency.

4.  T, F, and Explain:  Both cartels and price ceilings tend to reduce product quality.

FALSE.  Price ceilings DO hurt quality; when you hold prices below the market-clearing level and create a shortage, sellers can cut quality without hurting sales because consumers are happy to get anything.  Rent control is the standard example.  However, cartels actually tend to raise product quality.  Every firm in a cartel is making a profit on the marginal unit produced.  They cannot cut prices to gain more customers, but by increasing quality they can quietly steal customers from other members of the cartel.  This is what happened under airline regulation - rates could not be slashed, so airlines attracted customers with lobster meals and such.

5.  The International House of Pancakes is debating whether to run its restaurants itself, or to use franchises.  IHOP can run them itself for \$500,000 per restaurant per year.  Franchisees can run them for \$400,000 per restaurant per year (since the franchisee's owner-manager has an incentive to run the them more efficiently than an employee-manager).  Each restaurant can expect to sell 100,000 pancake breakfasts per year; because they face competition, they must be produced in the lowest-cost way and priced at average cost.

T, F, and Explain:  If the typical franchisee has a 5% chance of successfully suing IHOP for an average net award of \$1,000,000, IHOP will not use franchises and charge \$5 per breakfast, leading to a total deadweight cost of \$50,000.

FALSE.  The average lawsuit costs only .05\$*1,000,000=\$50,000.  So franchising is still cheaper than direct ownership, costing \$450,000 instead of \$500,000.  Pancakes therefore cost \$4.50 in equilibrium.  IHOP and the franchise will hire lawyers and experts to fight out any lawsuits; with full dissipation, the deadweight costs will equal \$50,000 exactly.

6.  "The suggestion was made, therefore, that the Federal Trade Commission order an end to model changes, at least by the larger firms, in order to reduce the size of automobile manufacturers." (Bork, The Antitrust Paradox)

T, F, and Explain:  Bork admits that product differentiation could reduce the number of firms able to fit in an industry, but still maintains that product differentiation is beneficial for consumers.

TRUE.  Bork acknowledges that differentiation raises fixed costs, and thereby reduces the number of firms that can fit in the market.  But he emphasizes that consumers get a valuable benefit in exchange: their taste for variety is better-satisfied.

(20 points each)

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

1.      David Friedman ("Monopoly I: How To Loose Your Shirt") writes that:

The obvious strategy of the cartel members is to tell any potential competitor that, as soon as he has sunk his capital into constructing a new firm, they will break up the cartel and return to competition.

Does Friedman think this threat will work?  Why or why not?

Friedman says this might work if prices are raised only a little bit.  Otherwise, he says, there is a simple response to this threat: Go to various possible consumers and make them sign a contract in advance to buy from you at a profitable price below the cartel price, IF you decide to enter the market.  Once you have signed up enough clients, you can begin production with a guaranteed client base.  This way, you do not risk losing your fixed capital investment; you know for sure that you will be able to sell your product at a profit regardless of the cartel's response.

2.  Is predation more or less likely to work in an illegal market?  Carefully explain your reasoning.

There are several reasons that cut in different directions.  On balance, I think these make predation harder, but I would accept either answer.

Predation is harder because (a) if you drive all of your competitors out of business, you are likely to attract a lot of police attention; and (b) producers in illegal markets have a shorter time horizon (they may go to jail and therefore go out of business), making it harder to recoup short-term losses from predation.

On the other hand, your competitors are not going to sue you under the antitrust laws, because if they admit to being in an illegal industry they will probably go to jail as well.

(A number of students pointed out that in illegal industries, firms were more likely to try to kill off their opponents.  That is true, but "predation" normally means cutting prices below MC, not any effort at all to hurt your competitors.  I did give partial credit for this answer, though).