Economics 370 Midterm #1

Prof. Bryan Caplan

Fall, 2000

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.  Two firms  - Turner and Warner - can potentially produce cable TV.  Both firms have the same MC of $10/customer.  But Turner's fixed cost is only $1000, while Warner's fixed cost is $2000.


T, F, and Explain:  Turner will serve the entire market, and charge a price just below Warner's MC.


FALSE.  Since there are fixed costs, Turner will charge a price just below Warner's AVERAGE cost, not MC.  If Turner priced just below Warner's MC, it would be losing money.  (In fact, since they have the same MC, Turner would lose money doing so even without fixed costs!)



2.  Suppose American and Japanese producers are equally efficient at producing cars.  The U.S. government passes a law forbidding the importation of Japanese cars, while continuing to allow unlimited competition between American firms. 


T, F, and Explain: The law will have no effect on allocative or productive efficiency.


TRUE.  Since U.S. firms still compete with each other, there is no allocative inefficiency; since they are as efficient as Japanese firms, there is no productive inefficiency.  This example is quite unrealistic - the whole reason for trade is international differences in efficiency - but given the assumptions the conclusion follows.


3.  David Friedman (The Machinery of Freedom) explains that airline regulation maintained ticket fares "at about twice their competitive level."


T, F, and Explain:  Half of the money spent on airline fares went to monopoly profits for airlines.


FALSE.  As Friedman explains, airlines switched to QUALITY competition.  Expensive meals, advertising, half-empty planes, etc. ate up much of their monopoly profits.  As Friedman puts it, "The effects of regulation are far more wasteful than a simple transfer...Without the CAB airlines would compete on price until the fare fell to fifty dollars, thus wiping out the extra profit.  With the CAB setting fares, they get the same effect by competing in less useful ways." (pp.41-2)



4.  "Selling stock short" enables an investor to make money when a stock price falls.  Suppose the Northwest Railroad has successively developed a reputation for predatory pricing.  You get a "hot tip" that a new railroad, Western Pacific, has secret plans to start competing with Northwest.


T, F, and Explain:  Selling Northwest short will be a good investment even if Northwest drives Western Pacific into bankruptcy.


TRUE.  The whole idea of predation is that the predator temporarily loses money to fight the entrant.  If the predator fails to drive out the predator, its monopoly profits dry up and its stock price plummets.  But even if the predator succeeds, its lifetime monopoly profits - and stock price - fall due to the period of severe losses it endures to stop entry.  A smart entrant could offset much of its risk by just shorting the predator's stock prior to announcing its plan to enter.




5.  Suppose that the government awards a monopoly privilege to produce wheat to whichever firm lobbies hardest.  An economist working for the government suggests that the government pass a second law forbidding the sole licensed wheat-grower to price discriminate.


T, F, and Explain:  This ban on price discrimination will hurt allocative efficiency without having any offsetting efficiency benefit.


FALSE.  A monopoly who practices price discrimination earns higher profits than a monopoly than can only charge a single price.  If firms competitively lobby for the privilege - so that total lobbying costs equal monopoly profits - lobbying costs will be higher if they are allowed to price discriminate!  The ban on price discrimination does indeed hurt allocative efficiency, but it increases the deadweight costs of lobbying.


6.  From the FTC webpage (


The Wisconsin Chiropractic Association, based in Madison, is an association of more than 900

 Wisconsin chiropractors, representing about 90 percent of the chiropractors licensed in the state... In January 1997, the federal government and many private insurance companies began using new billing codes for chiropractic manipulations.  According to the FTC's complaint... Leonard advised chiropractors to raise their prices to specific levels, and assured members that if they all raised their rates, third-party payers would not reject or reduce these higher charges for the new codes.


T, F, and Explain:  The FTC action is extremely unlikely to reduce allocative inefficiency, but also unlikely to reduce productive efficiency.


TRUE.  It is extremely unlike to reduce allocative inefficiency because there are 900 people in this price-fixing agreement.  Firms might be able to control cheating with 5 or 10 firms, but it would be impossible to control with nearly a thousand participants.  At the same time, the FTC move would have no impact on productive efficiency - they aren't preventing chiropractors from taking advantage of scale economies or otherwise telling them how to serve their customers.

Part 2: Short Answer

(20 points each)

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


1.      Posner (Economic Analysis of Law, pp.311) writes:


[T]he cartels most likely to be discovered and prosecuted are those in which the price and output effects are small.


Carefully explain Posner's reasoning.


The more members a cartel has, the harder it is to make it work: the more members there are, the harder it is to control cheating, to entice all of the potential "hold-outs" to join, and so on.  Cartels with a small number of firms might work, but with many firms, they are basically sure to fail.  What Posner observes, however, is that the antitrust laws put the most severe penalties on explicit price-fixing deals.  But as with any other secret, the odds that it remains a secret decreases as the number of people who know it increases.  Thus, if 1000 firms conspire to fix prices, it won't work, AND the government is almost sure to find out.








2.  Restrictions on the satellite TV industry have recently been reduced.  How is this likely to affect the cable TV industry, which continues to be supplied by licensed monopolists?  Carefully explain the probable impact on the price and quality of cable TV, using simple diagrams to illustrate your argument.  Are there any deadweight losses associated with legal satellite TV?


Think of cable TV as a contestable monopoly facing potential competition by satellite.  The more regulations placed on satellite, the weaker the constraints of potential competition are.  By relaxing the constraints on cable, you essentially reduce the cost curves for potential competition.  Cable TV suppliers have to cut their prices to maintain their dominant market position.  (Of course, this story is too simple, because cable and satellite are not identical products; thus, both can supply part of the market at the same time because the "best deal" for one person is not always the "best deal" for someone else).  If cable and satellite provided truly identical products, then you could think of the costs of building and maintaining the satellite as a deadweight loss.  Everyone could enjoy TV services using only existing cable technology, much like everyone could watch a matinee movie using only existing seats.  Insofar as satellite actually provides a different quality of product, though, this argument doesn't work.