Prof. Bryan Caplan

Fall, 1997

Economics 370

Answers for Midterm #1

Part 1: True, False, and Explain

(10 points each - 3 for the right answer, and 7 for the explanation)

State whether each of the following six propositions is true or false. In 2-3 sentences, explain why.

1. "It cost $24.30 to produce a bale of cotton yarn in a Shanghai spinning mill that was Chinese-owned, but only $14.90 in a Japanese-owned factory. The labor cost was $10.50 and $5.80, respectively, although wage scales were similar. The Chinese mill simply used more workers." (George Botjer, A Short History of Nationalist China)

T, F, and Explain: According to the above quotation, the Chinese firms were allocatively inefficient.

FALSE. The Chinese firms were productively inefficient because the Japanese firms were able to produce the same output using fewer workers. Therefore, the Chinese firms were not producing at minimum possible AC.

2. Production in the cable TV industry involves a fixed cost (laying the wire, setting up the station, and so on), plus a marginal hookup cost (sending cable guys to each client's home for installation).

T, F, and Explain: If the current cable provider faces equally efficient potential competitors, they will have to set the price of cable equal to its marginal cost.

FALSE. The current cable provider will have to set price equal to average cost. If it priced at marginal cost, it would be losing money. So long as its price remained below average cost, potential entrants would have no incentive to enter.

3. The state of Virginia holds a monopoly over the sale of lottery tickets. It is illegal for anyone else to sell lottery tickets in the state.

T, F, and Explain: If the state monopoly were abolished, the price of tickets will fall and/or the size of the prizes will increase.

TRUE. This follows from the standard theory of monopoly: a monopolist sets prices higher and output lower than they would if they faced actual or potential competition. Therefore the price of the ticket will fall once the monopoly is abolished (or the expected prize per ticket could grow, which is basically the same thing).

4. T, F, and Explain: If the government auctions off monopoly privileges rather than giving them away, there may be gains to productive efficiency, but the deadweight costs from lobbying will be larger.

FALSE. There will be gains to productive efficiency, AND the deadweight cost will be SMALLER. Auctioning a resource rather than giving it away eliminates the incentive to lobby.

5. T, F, and Explain: Collusion in an industry already losing money is just as difficult as any other kind of collusion.

FALSE. Collusion becomes easier because there is no longer any need to fear new entrants. One of the main problems facing would-be colluders disappears.

6. T, F, and Explain: A vigorous deconcentration policy would be least destructive in an industry with a horizontal AC curve.

TRUE. In an industry with a flat (horizontal) AC curve, costs won't rise just because the size of firms is forcibly reduced. In contrast, in an industry with normal, U-shaped curves, reducing the size of firms raises AC.




Part 2: Short Answer

(20 points each)

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


  1. There are several problems that would-be colluders face. The NRA (discussed in the readings from Schlesinger) used the government to help firms solve these problems. Discuss ANY TWO of the problems with collusion that that the NRA tried to solve for participating businesses. Was the government's assistance sufficient to solve the problems, or not?
  2. Businesses participating in the NRA had at least two problems. First, they faced the problem of "cheating." Businesses wanted to raise prices, but every business had the incentive to undersell the official price to get more business. The NRA tried to solve this problem by setting up price and quality codes for members to follow. Second, they faced the problem of the "hold-out." In many industries, some firms (such as Ford) refused to go along with the NRA's plan. They wouldn't join, in spite of Johnson's threat to give them a "punch in the nose." The government's assistance did not help much, because the penalties were very mild. You just got bad publicity and couldn't display the Blue Eagle, but you were not fined, joined, or put out of business.

  3. Explain why Demsetz's study (showing that market share is positively correlated with profits, while concentration is not correlated with profits) indicates that market monopoly-by-efficiency is a significant factor in the U.S. economy, but market monopoly by predation and/or collusion is not.

Demsetz's study found that in concentrated industries, only the market leaders have unusually high profits; controlling for market share, concentration has no impact on profitability. If collusion were the cause of high profits, one would expect ALL firms in a colluding industry to do well, not just the market leader. (The same goes for predation). On the other hand, if superior efficiency were the cause of the market leaders' high profits, it would make sense to see the lowest-cost firms selling the most output and earning the largest return. Demsetz's results therefore tended to discredit the idea that collusion and predation are significant forces in the U.S. economy - because these would predict a positive correlation between concentration and profits, not market share and profits. His results however were consistent with a substantial role for monopoly-by-superior efficiency.