Prof. Bryan Caplan

Fall, 1997

Economics 370

Answers for Midterm #2

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. T, F, and Explain: The expected net profits of R&D firms will be zero whether or not patents exist.

TRUE. Without patents, the expected net profits of R&D firms would be zero, just like with any other industry. But if you add patents, firms will invest more in R&D; and firms will keep entering the market until the expected net profits become zero again. The moral: patents increase the profits of R&D, but this merely induces additional investment in R&D until the additional profits are balanced by additional costs.

2. Suppose a new flavor of ice cream has a fixed cost of introduction, and a constant marginal cost of production.

T, F, and Explain: More demand for this flavor initially reduces its price, but eventually increases the price.

FALSE. Given the assumptions, AC is continually declining. More demand tends to reduce the price, since potential competition forces the firm to produce where the demand curve intersects the AC curve. In reality, of course, the AC curve will eventually have to turn up, but not under the assumptions given.

3. Suppose my book has a zero marginal cost of production (you just download it off the web). The total area underneath the demand curve for my book is \$50,000; the book would take a year to write, time I value at \$40,000.

T, F, and Explain: I will choose to write the book.

FALSE. I can only capture the whole area under the demand curve by practicing perfect price discrimination. Since it is unlikely that I can successfully do this, there is a non-appropriability effect which might lead me to refrain from writing the book even though the social benefits exceed the social costs. Some people answering this question assumed that I would be unable to charge for my book at all; but you can charge for webbed services. The problem is that I can't get all of the area under the demand curve, not that I can't get any of it!

4. T, F, and Explain: According to search theory, if you have to search for a job, then you are probably overpaid; if employers search for you, then you are probably underpaid.

TRUE. It would only be worth your while to spend time searching for a job if it paid somewhat more than your next best alternative. Similarly, it would only be worth employers' time to search for you if they could pay you somewhat below your full value to them.

5. Suppose that my actuarially fair premium without a deductible is \$1000 (I am insuring against a 1-in-10 probability of \$10,000 worth of damage to my car).

T, F, and Explain: The actuarially fair premium for a policy with a \$1000 deductible will surely be \$900.

FALSE. The actuarially fair premium is defined as the PROBABILITY*PAYOFF. So if the probability remained .1, the actuarially fair premium would be \$900 (since you would receive \$10,000 - \$1000= \$9000). However, due to the moral hazard problem, you would expect that adding a deductible would reduce the probability of the accident! (Of course, there will not always be a reduction of moral hazard - that's why I put the word "surely" into the T/F statement). The deductible gives you a bigger incentive to exercise caution. So the actuarially fair premium would actually be less than \$900.

6. "Discrimination in pay against the first Japanese immigrants eroded as Japanese Americans became farmers and employers of Japanese farm laborers. Initially, white farm laborers were paid more by the hour than were the Japanese but received less when both were paid on a piecework basis because the Japanese workers produced more output." (Thomas Sowell, Ethnic America)

T, F, and Explain: The Japanese workers could have signaled their farming ability by insisting on hourly rather than piecework rates.

FALSE. (In case you were confused about the meaning of "piecework": it means that you get paid per unit produced). If you are more able than average, piecework payments are beneficial to you because you will then receive above average pay; if you are less able than average, hourly payments are beneficial to you because you will then receive average pay instead of the below-average pay that you're worth. So the way for the Japanese to signal their ability was to offer to work on a piecework basis: Only exceptionally productive workers would wish to make such a contract. [P.S. There wouldn't have been a problem bringing a dictionary for the exam!]

Part 2: Short Answer

(20 points each)

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

1. Explain why the safety of alcohol declined during the Prohibition era. Analyze the impact (good and/or bad) of organized crime on the welfare of alcohol consumers during this period.
2. Safety on the (legal) free market is sustained by firm's reputations, and their ability to offer warrantees. Prohibition makes these checks work much more poorly, because it becomes dangerous to have a prominent reputation (it makes it easier for the cops to catch you), and difficult to enforce a money-back warrantee. This means that purveyors of alcohol had an incentive to cut corners with risky production and distribution techniques than endangered the lives of their customers. Organized crime had both positive and negative effects on the illegal market. The main positive effect was to maintain quality: since organized crime bribes law enforcement and dominates the prisons, it was much safer for alcohol vendors affiliated with organized crime to build up a reputation for supplying safe liquor. The negative effect of organized crime was that they sometimes killed competitors to gain monopoly privileges for themselves.

3. In "People Wanted," Landsburg argues that a larger population tends to increase everyone's economic well-being. State TWO of his arguments. Are these arguments sound? Why or why not?

First, Landsburg argues that a larger population implies a larger number of inventive geniuses. Since the one invention can be enjoyed by any number of people, average welfare goes up when the total number of inventive geniuses rises. Or in other words, (more people)-->(more geniuses)-->(more inventions)-->(higher average standard of living). That looks like a sound argument to me (although it is a particularly good argument for encouraging geniuses to bear more children!).

Second, Landsburg argues that a larger population generates more potential friends and mates. This is a variant on the argument we discussed earlier, to the effect that more population makes it feasible for more variety to exist. How well would you get along on an island with ten randomly selected people? Probably not too well - you wouldn't have enough choice. Again, this argument makes sense to me. If my wife had been unable to leave Romania as a child, where would I be today? Probably single and lonely. :-)