Economics 812 Final

Prof. Bryan Caplan

Spring, 2006




        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.












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.







Part 2: Short Answer

(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.