Economics 370 Midterm #2

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. Drug companies often sell drugs more cheaply in poorer countries.

T, F, and Explain:  This pricing practice may actually hurt people in poor countries by reducing the rate of medical innovation.

FALSE.  Drug companies reduce prices in poor countries to price discriminate; they would actually earn less in poor countries if they charged more.  This is doubly beneficial for people in poor countries - they get cheaper drugs, and increase the rate of medical innovation by making it more profitable.

2.  Imagine that the government bans the QWERTY keyboard for 10 years, long enough for every keyboard in the country to be replaced by a non-QWERTY keyboard.  The government then re-legalizes the QWERTY keyboard.

T, F, and Explain:  The path-dependence story says that the QWERTY keyboard will be unable to regain its original popularity.

TRUE.  According to the path-dependence story, people use one kind of keyboard because everyone else uses it, too.  Once the QWERTY keyboard disappears, re-legalizing it won't revive it, because at that point, everyone will be using a different keyboard.  (Of course, if QWERTY does make a come-back, this suggests that path-dependence wasn't very important in the first place).

3.  During the Great Depression, the federal government tried to prevent the price level from falling, but it was more successful in some markets than others.

T, F, and Explain:  The more "successful" the government was in preventing declining prices in a given market, the more the quality of products in that market would have tended to rise.

TRUE.  When the government imposes price floors, there are surplus goods.  Sellers can unload their surplus by raising quality (for example, by raising the quality of meals for regulated air travel).  The more effective the floor is, the stronger the incentive to raise quality.

4.  T, F, and Explain:  Salad bars may "unravel" due to asymmetric information, but do not suffer from a moral hazard problem.

FALSE.  An all-you-can-eat salad bar can suffer from both problems.  The first is that the people with big appetites are more likely to choose the all-you-can-eat option.  The second is that all people, regardless of their appetites, will eat more if the marginal cost is zero.  (A number of people looked at salad bars from the seller's point of view rather than restaurant patrons.  I gave these partial credit based on the quality of the answer).

5.  You find a \$20 bill lying on the sidewalk.

T, F, and Explain:  This is inconsistent with search theory.

FALSE.  Search theory only says that the EXPECTED marginal benefit of search equals the marginal cost.  It does not rule out good or bad luck.  Moreover, search theory focuses on the marginal benefit.  It is quite possible for there to be many easy opportunities, and we should expect people to take advantage of these first!

6.  T, F, and Explain:  Giving one firm a monopoly on education would definitely make prospective students worse off, even if education is 100% signaling.

FALSE.  The monopolist will reduce quantity and raise price; students will accordingly buy less education.  However, for signaling education, if everyone buys less, everyone needs less to get a job.  You can signal just as much about your personal qualities by buying a little expensive education as you can be buying a lot of cheap education.

Part 2: Short Answer

(20 points each)

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

1.  Posner (The Economic Analysis of Law) notes that inventions can only be legally patented if they are "non-obvious."  What economic rationale does Posner provide for this feature of the law?

Posner (pp.43-4) explains that "the functional meaning of obviousness is, discoverable at low cost."  Patents provide incentives to come up with new ideas; but if an idea is obvious, few or no incentives are needed to induce its discovery.  In fact, Posner explains, strong patent protection for obvious ideas can easily lead to over-investment; inventors might spend massive resources trying to list and patent every conceivable idea, however obvious, "just in case" one turned out to be profitable.

2.  Why do people vote?  Robin Hanson (in personal conversation with me) suggested that people vote so they don't "look bad" in the eyes of their family and friends.  Carefully explain how Hanson's claim can be used to develop a signaling theory of voting.  (Hint: How might voters and non-voters unobservably differ?)

One way voters and non-voters might differ: voters might be more conscientious, more concerned to "do what they're supposed to do" than non-voters.  It is hard to observe conscientiousness.  But it is easier to observe whether someone votes, and more conscientious people will on average find voting less burdensome than others.  For conscientious people, it will be relatively painless to register, remember the day of the election, stand in line, and so on.  The opposite holds for "free spirits."  To complete this story, we need only to assume that people prefer to associate with conscientious people - people they can rely on.

(I gave significant partial credit to answers that said that voting is a signal of patriotism.  It may well be, but why would family and friends care about patriotism?  They might, but only if patriotism correlated with loyalty to friends and family or something along those lines).