Name:_______________________

Economics 812 Final

Prof. Bryan Caplan

Spring, 2011

Instructions:

· You have 2 hours 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 120.

· You should have five 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. In a world with no externalities, suppose the government imposes a lump sum tax and uses it to fund an hourly work subsidy.

True, False, and Explain: The deadweight cost of this tax-and-subsidy policy is zero.

2. Suppose two people repeatedly play the Dictator game. Player 1 gets to be the Dictator in odd-numbered turns; Player 2 gets to be the Dictator in even-numbered turns. β≤1 for both players. After each turn, the game ends with 99% probability.

True, False, and Explain: An equilibrium where the Dictator always offers even splits (50/50) may be sustainable if the stakes increase over time.

3. Consider a simple auction.

True, False, and Explain: As long as actors have RE, the Winner’s Curse will not cause the market to “unravel.”

4. “The average person considers himself better than average by a variety of measures. But vulnerability to such biases is still far from universal. Robins and John (1997) surprisingly report

that ‘only about 35 percent of the subjects show a clear self-enhancement bias whereas about

50 percent are relatively accurate and about 15 percent actually show self-diminishment

bias’ (p. 669).” (Caplan, “Stigler-Becker vs. Myers-Briggs”)

True, False, and Explain: By itself, this result suggests that self-enhancement bias will affect market outcomes, but not democratic outcomes.

5. Suppose foregone earnings are the sole cost of education, and people live forever. Without school, workers earn $10,000 per year; every year of school completed boosts earnings by 10%.

True, False, and Explain: Without externalities, the social rate of return to education is 10%.

6. True, False, and Explain: Wittman admits that in a federal system, restraining government spending is a public good.

Part 2: Short Answer

(20 points each)

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

1. Historians often argue that wars arise due to irrationality, not just bad luck. What simple game theory model are historians implicitly rejecting? How could historians use Thaler’s The Winner’s Curse to persuasively defend their position? Be specific.

2. “Contrary to e.g. Krugman, insurance isn't a ‘special’ market where laissez-faire doesn't work.  Instead, it's a normal market where democratic politics doesn't work, because both the public and economists remain wedded to populism and paternalism.” (Me on my blog)

Carefully explain why I would say this. Name two examples I might use to support my position. Am I right? Why or why not?

3. Workers deeply resent nominal wage cuts. Voters deeply resent inflation. Use these two stylized facts to build a simple, depressing model of the economic and political effects of negative shocks to Aggregate Demand. Make sure you discuss the interaction between economics and politics.