Economics 370 Midterm #1 Answers

Prof. Bryan Caplan

Fall, 1998


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. Malthus argued that workers would always tend to earn their bare subsistence: if workers earned less, they would die; if they earned more, they would reproduce without limit.

T, F, and Explain: If Malthus’ assumption about labor supply is correct, then increases in labor demand will change neither wages nor the quantity of workers employed.

FALSE. Malthus' argument implies a horizontal labor supply curve. An increase in labor demand will therefore increase the quantity of labor employed even though wages will always remain at subsistence.

2. T, F, and Explain: Large monopoly profits are consistent with allocative efficiency.

TRUE. If the monopolist practices perfect price discrimination, there would be monopoly profits but no allocative inefficiency. (The question said "consistent with," not "normally associated with").

3. Three firms with constant marginal costs compete in the production of identical computers. Firm #1 has a MC of $1000; firm #2 has a MC of $1000; firm #3 has a MC of $2000.

T, F, and Explain: If the government makes it illegal for firm #1 to produce computers, the sole result will be allocative inefficiency; if the government makes it illegal for either firm #1 or firm #2 to produce computers, the sole result will be productive inefficiency.

FALSE. If firm #1 cannot produce, there will be allocative inefficiency; if neither firm #1 nor firm #2 can produce, there will be both allocative and productive inefficiency. In the first case, firm #2 takes the whole market and charges $1999. In the second case, firm #3 takes the whole market, and charges more than $2000 (After all, it faces no potential competition, so it will want to charge more than its MC).


4. T, F, and Explain: Predation is harder in markets for durable goods.

TRUE. In markets for durable goods, consumers can take advantage of temporarily low prices to buy a long-term supply that will not "spoil" for a long time. If cars, for example, were priced at $1000 for this month, and at $100,000 thereafter, consumers could buy their next two or three cars at the temporarily low price without much trouble, and wouldn't need to buy another car for 15 years.

5. T, F, and Explain: If an economy has a significant level of collusive monopoly but no significant monopoly achieved through superior efficiency, profits would be correlated with market share but not industry concentration levels.

FALSE. It's exactly the opposite: if there were a lot of collusive monopoly but no monopoly achieved through superior efficiency, profits would correlate with concentration and would not correlate with market share.

6. The FTC recently settled a lawsuit against a group of Puerto Rican dentists who allegedly fixed prices. Paragraph 12 of the FTC’s legal complaint reads:

The respondents have not integrated their businesses in any economically significant way, nor have they created any efficiencies that might justify the acts and practices described...

T, F, and Explain: If the court found that the FTC’s claim in paragraph 12 were incorrect, then the dentists’ practices would probably be judged by a "rule of reason" rather than declared illegal per se.

TRUE. If the respondents had integrated their businesses, they could argue that they were actually one firm to begin with, and were therefore merely discussing their firm's pricing policy, not their firms' pricing policies. That would not constitute price-fixing, so their behavior would be judged by the rule of reason.


Part 2: Short Answer

(20 points each)

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


  1. Rothbard (Power and Market) argues that many regulations are actually smoke-screens for government grants of monopoly privilege. Pick one of Rothbard’s examples and briefly (1 sentence) explain the effect he says it has on competition. Then state and defend the strongest efficiency rationale for the regulation Rothbard attacks. (Hint: Don’t forget the difference between transfers and deadweight losses).

Your example may vary; here's mine:

Rothbard argues that antitrust laws themselves hinder competition. Antitrust laws punish more efficient firms for successfully winning market share. Efficiency rationale (most people didn't even try to give one): Even if antitrust laws punish more successful firms, they also prevent price-fixing and collusion. Price-fixing and collusion tend to raise price above MC, creating allocative inefficiency.

2. Explain why Landsburg ("Why Taxes are Bad") says it is inefficient to jump to catch a dollar bill. Would it also follow that it is inefficient to hunt for sunken pirate treasure?

It depends on what the treasure is: if the treasure were merely dollar bills, then Landsburg would be correct. But if the treasure included gold, jewels, art, etc., then the pirate treasure is a real resource like any other. Finding such treasure adds to the total stock of real wealth. (Even if gold is used as money, it also has industrial and decorative uses as well, so finding more gold is not a pure transfer from the world to the finder).