Economics 370 Midterm #2

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. Monopolies attributable to patents or copyrights are normally immune from antitrust scrutiny.


T, F, and Explain:  Whatever damage it does in other respects, antitrust has no impact on the rate of innovation.


FALSE.  Patents and copyrights are not the only incentive to innovate.  Another important one is the first-mover advantage, an incentive that antitrust attacks on market leaders weaken.






2. Many people argue that raising the minimum wage will not increase unemployment.


T, F, and Explain:  One internally consistent argument for their position is that employers will respond by making working conditions less pleasant (requiring faster work, giving fewer breaks, etc.)


TRUE.  As with other price controls, surpluses can be eliminated if the quality of the product rises (from the point of view of the buyer!).  Just as airlines can sell surplus seats by giving away free lobster dinners, workers can sell surplus labor by offering to work quickly, without breaks, etc.





3.  T, F, and Explain: A poor person living in a rich country is better off because products are made to higher quality standards.


FALSE.  A poor person living in a rich country is worse off because few cheap, low-quality items will be on the market.  This makes it more difficult to get by on a small income.








4.  Tourists often complain that they pay high prices at "tourist traps."


T, F, and Explain:  According to search theory, banning tourist traps would actually raise the prices tourists pay, even if you don't count the tourists' opportunity cost of time.


FALSE.  Tourist traps help tourists save time (the sellers find the tourists, so the tourists don't have to find the sellers), but in order to compensate the sellers for their search effort the tourists have to pay a higher price.  The tourists are better off because they saved valuable time by paying a little extra.






5.  Empirical studies indicate that people with safe and healthy lifestyles tend to buy more life and health insurance than people with unsafe and risky lifestyles.


T, F, and Explain:  This is the opposite of what the usual "adverse selection" story predicts.


TRUE.  The "adverse selection" story claims that people with unsafe and risky lifestyles are MOST likely to buy insurance: they get to pay the average rate, even though they can expect to get more than the average payout.  Conversely, the adverse selection story claims that people with safe and healthy lifestyles have the least to gain from insurance, and are therefore the most likely to do without it.







6.  "The more costly a mistake is, the less likely it is to be committed; and a mistake in choosing a spouse is more costly in a system that forbids divorce (or makes it more difficult) than in one that permits it... So there is the curious paradox that making divorce more difficult may actually foster happy marriages!" (Richard Posner, Economic Analysis of Law)


T, F, and Explain:  Posner's analysis applies signaling theory to marriage.


FALSE.  Posner just applies search theory, as his explicit reference to "marital search" on p.160, and the continuing discussion on p.161 make clear: "In a system where divorce is very difficult, prospective marriage partners (or their parents or other intermediaries) conduct a careful investigation into the qualities of the most promising prospect..."  If he were thinking in terms of signaling, Posner would have discussed the difficulty of signaling serious intent in a legal system with easy divorce, the possibility of inefficient signaling, and so on.







Part 2: Short Answer

(20 points each)

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


1.  Most industry experts believe that pharmaceutical R&D would sharply decrease without patent protection.  What does this imply about R&D in the market for illegal narcotics?  How does the presence or absence of organized crime affect the rate of innovation in the narcotics industry?


Assuming they are just like other pharmaceuticals, this suggests that there will be little R&D in the market for illegal narcotics; after all, if a product is illegal, you can hardly get a patent for it!  So while law enforcement authorities often complain about new strains of prohibited drugs, there would be a lot more innovation if drugs were legalized.  Organized crime may explain some of the innovation that actually happens: just as they can enforce their own contracts, they may also be able to protect their right to be the sole producer of new drugs their invent.  Just as organized crime helps maintain the quality of illegal products, it may also be responsible for improvements in illegal products.







2.  Robin Hanson, in "Showing that You Care: The Evolution of Health Altruism," discusses three specific sorts of facts people might want to signal by providing health care for another person.  Pick ONE of these.  Explain what assumptions Hanson has to make about (a) types, (b) observability, and (c) signal costs, in order for his argument to make sense.


Hanson discusses: (i) "Showing that I'm able"; (ii) "Showing that I'm staying"; and (iii) "Showing that you're staying."  I pick (iii).  For this argument to make sense, Hanson has to assume that there are different types of people - some are planning on leaving soon, others are planning on hanging around.  He has to assume that you cannot distinguish between these types by looking at them.  Finally, he has to assume that it is cheaper (or more beneficial) to help people who are going to stay than people who are leaving.  By providing health care to someone, you are showing that you have reason to believe that they are going to hang around.