Name:_______________________

Economics 812 Final

Prof. Bryan Caplan

Spring, 2006

Instructions:

·        You have 2 hours and 30 minutes to complete this exam.

·        Write directly on the exam.

·        You may use any books, notes, or other materials that you wish, but avoid spending too much time on any one question.

·        Partial credit may be awarded on all questions.

·        The maximum possible number of points is 150.

·        You should have 6 pages, counting this one.

Part 1: True, False, and Explain

(10 points each - 2 for the right answer, and 8 for the explanation)

State whether each of the following nine propositions is true or false.  Using 2-3 sentences AND/OR equations, explain your answer.

1.  Suppose 35% of all agents in an economy have U=ln x + ln y, and the other 65% have U=.5 ln x + ln y.  All agents start with one unit of x and three units of y.

True, False, and Explain:  In general equilibrium, exactly 65% of the agents consume more y than x.

2. Suppose that two players play the following game.

 Left Right Left 0,0 4,2 Right x,4 0,0

For Type A players, x=6; for Type B players, x=1.  Players know both their own type and their opponent's type.

True, False, and Explain: If Player 1 is Type A, there is no MSNE.  If Player 1 is Type B, there is a MSNE, but since it is not focal, in practice we would not expect it to happen.

3.  True, False, and Explain:  Cournot competition with free entry, zero fixed costs, and constant marginal costs leads to a perfectly efficient outcome.

4.  Suppose demanders of insurance are risk-averse, but suppliers of insurance are risk-neutral.

True, False, and Explain: As long as they have rational expectations, demanders will buy some insurance.

Questions 5 and 6 refer to the following information:

There are two kinds of workers, good and bad.  Both types are equally numerous.  Good workers are worth \$100k to me; bad workers are worth \$25k to me.  It costs both kinds of workers \$5k to finish school.  I can tell if a worker finished school, but cannot observe their quality directly.  Workers earn 40% of their value to me if they choose to be self-employed.  Finally, assume that if a worker fails to go to school, I automatically conclude that he is bad.

5.  True, False, and Explain: Everyone goes to school and earns the same wage.

6.  Suppose workers earn 80% of their value to me if they are self-employed.

True, False, and Explain:  Only bad workers will go to school, and will earn a net wage (wages minus schooling costs) of \$20k.

7.  "[L]oss aversion says that the value function abruptly changes slope at the reference level, so that people dislike even small-scale risk."

"While people are likely to be risk averse over gains, they are often risk-loving over losses."  (both quotes from Rabin, "Psychology and Economics")

True, False, and Explain:  These two statements are inconsistent.

8.  Suppose that education causes a temporary increase in intelligence, but the effect "fades-out" after a year.

True, False, and Explain:  Controlling for intelligence, the estimated effect of education is downwardly biased.

9.  Caplan argues that irrationality has psychological benefits for many – if not most – people.

True, False, and Explain:  Economic theory cannot say whether the private psychological benefits of irrationality exceed its social costs.

(20 points each)

In 4-6 sentences AND/OR equations, answer each of the following three questions.

1.  Suppose you have two potential producers in a contestable industry with SUNK costs.  TC=1000+10Q.  Demand is given by Q=100-P.  In a MSNE, what is the probability that there are (a) 0 firms; (b) 1 firm; (c) 2 firms?

2.  Caplan's "Systematically Biased Beliefs About Economics" controls for various measures of self-serving bias and ideological bias.  Argue that he should not have controlled for these variables, and that as a result, his final estimates underestimate the magnitude of the public's biases.  (Hint: What is the direction of causation?)

3.  Clearly explain how a behavioral anomaly of your choice helps to mitigate a market failure of your choice.  Be as original as possible.