Economics 370 Midterm #1 Answer Key

Prof. Bryan Caplan

Fall, 1999

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. Suppose the fixed cost of buying groceries is $10 (the time of the trip, gas, etc.), and the marginal cost is $2 per bag of groceries. The groceries stay fresh for a week, and then become inedible.

T, F, and Explain: Your AC curve of getting groceries is upward-sloping over its entire range.

FALSE. The AC is actually downward-sloping over its entire range, since there is a fixed cost and marginal costs are constant. The total cost curve, as always, is upward-sloping over its entire range.

2. Suppose all consumers in a market either buy one car or none. Each buys one car if the price is $12,000 or less, and zero cars if the price is higher.

T, F, and Explain: If the government randomly gives one car producer a monopoly over car production, there will definitely be allocative inefficiency and may be productive inefficiency.

FALSE. Given the assumptions, all firms with MC of $12,000 or less will set their price at $12,000 (at higher, they get 0 sales; at lower, they get no more sales). If the winning firms' MC cost is $12,000 or more there will be no allocative efficiency because price will not be greater than MC. There will be productive efficiency unless the most efficient firm wins the monopoly. The correct answer would thus read: "there may be allocative inefficiency and may be productive inefficiency."

3. Suppose the liquor industry in Virginia initially allows free competition. The government then auctions off the right to be the sole seller of liquor in the state.

T, F, and Explain: The revenue the government raises will equal the expected amount of consumer's surplus all purchasers of liquor lose.

FALSE. This ignores deadweight costs! The government will thus raise less in revenue than consumers lose.






4. "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 "cheating."

FALSE. This illustrates the problem of the HOLD-OUT. Cheating occurs when members agree to join a cartel but don't abide by the agreement. The hold-out problem occurs when a firm refuses to join the cartel, hoping other firms will restrict their output even though it does not.


5. T, F, and Explain: Even though antitrust laws prevent some vertical mergers, they also indirectly encourage some forms of vertical integration.

TRUE. As explained in lecture, suits by franchisees against franchisors are quite common. Firms can avoid this suits by owning their distributors directly rather than using franchising - i.e., but increasing their level of vertical integration.

6. From the FTC webpage (

Toys "R" Us, the nationís largest toy retailer, was ordered today by the Federal Trade Commission

to stop engaging in illegal practices that keep toy prices higher and reduce choice for consumers. Toys "R" Us, the FTC said, was concerned that warehouse clubs -- with substantially lower prices -- presented a threat to its low-price image and its profits. The Commission determined that to eliminate this threat, Toys "R" Us used its dominant position as a toy distributor to extract agreements from and among toy manufacturers to stop selling to warehouse clubs the same toys that they sold to other toy distributors.

T, F, and Explain: Toys "R" Us will now be able to negotiate lower prices from the toy manufacturers with which it had these agreements.

TRUE. There are (at least) two different ways for Toys "R" Us to take full advantage of its monopoly power over its suppliers: It can impose unfavorable contractual terms and offer one price, or impose favorable contractual terms and offer a lower price. Banning the first route, Toys "R" Us will turn to the second, legally safe route.





Part 2: Short Answer

(20 points each)

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

  1. Posner (Economic Analysis of Law, pp.330) writes:

If the monopolist could somehow develop a reputation for implacable, irrational rage at anyone who had the temerity to enter a market in which he was the sole seller or to undersell him... then his threat to retaliate against an entrant by selling below cost no matter how much money he lost in the process would be no bluff and he would not have to make good on his threat.

How effective does Posner think this tactic is likely to be? Explain why Posner reaches this conclusion.

Posner says that this tactic will be ineffective. Why? "It is hard for a person desiring such a reputation to convince the world that he is not really a rational person simulating irrationality." If such a threat worked, everyone would make it, but then making it would not actually prove anything. This is another way that successful predation is difficult to actually practice.



2. Assess the consequences - positive and negative - of abolishing antitrust laws for ONE of the following: allocative inefficiency, productive inefficiency, or "lobbying."

I choose to analyze the consequences for "lobbying." There are clear efficiency gains of antitrust abolition here: if there is no more antitrust law, there is no more incentive to hire lawyers, lobbyists, etc. to try to get favorable changes in antitrust laws. More importantly, there is no need to hire lawyers and expert witnesses for private antitrust cases, whether as plaintiff or defendant. The government's enforcement costs can also be saved.