Economics
812 Midterm
Prof.
Bryan Caplan
Spring,
2009
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. True, False, and Explain: In
practice, ex ante Pareto efficiency
is equivalent to Kaldor-Hicks efficiency, because in the long-run, the benefits
of allowing uncompensated Kaldor-Hicks improvements more than cancel out the
losses.
FALSE. While many, perhaps most, people will be ex
ante better off if you allow uncompensated K-H improvements, in the real world
it is still extremely unlikely that everyone
will be better off. As I said in the
notes, “someone somewhere is sure to slip through the cracks.” As a result, the ex ante Pareto efficiency
standard, unlike the Kaldor-Hicks efficiency standard, ends up approving of
every status quo.
Problems 2 and 3 refer to the following information.
2. Agents live for two periods. They are endowed with 1 unit of a consumption good in period 1 and 2 units in period 2. The period 1 good spoils if not consumed in period 1. There are two types of agents:
Type A: 10% of the agents have U=ln c2.
Type B: The other 90% have U=ln c1 + ln c2
True, False, and Explain: The general equilibrium interest rate will exceed 200%.
FALSE. Normalize the two utility functions, then
apply the formula from the notes to get , implying a 64% interest
rate.
3. True, False, and Explain: If the two types of agents do not interact (i.e., there is one island
for all of the A's and a different island for all of the B's), the interest
rate on A will be positive but the interest rate on B will be negative.
FALSE. Applying the formula from the notes, we see that on the type A’s island:
, implying a -100% interest
rate (not, as many people said, negative infinity!). Intuitively, on the island where no one
values consumption in period 1, lending in period 1 consumption buys you
nothing in period 2.
Similarly, on the type B’s
island:
, implying a 100% interest
rate. Intuitively, the type B’s value
both kinds of consumption equally, but have a larger endowment in period 2, so
they try to borrow against their higher future earnings.
4. Consider the following normal form:
|
Left |
Right |
Left |
2,2 |
0,0 |
Right |
0,0 |
0,0 |
True, False, and Explain: This game has one PSNE and one MSNE, but it can be solved through weak dominance.
FALSE. The game has two PSNE: (Left, Left), and
(Right, Right). It has no MSNE – if you
try to solve for one, you just get “play Right” with 100% probability for both
players. The game can however be solved
through weak dominance: Left is sometimes better the Right, and never worse.
Problems 5 and 6 refer to the following information.
Kreps imagines a monopolist’s monologue:
Out
there are many people who would enter this industry and take away my profits if
they thought they that they could themselves make a profit... My choice of an
output level of 5 may look silly in the short run, but if it keeps you (and
other potential entrants) out of my market, it is a good strategy to employ.
5. True, False, and Explain: Kreps’ monopolist engages in “limit pricing.”
FALSE. The notes explain that “limit pricing” is
when the lowest-cost firm sets its price just below the costs of the
second-lowest-cost firm. In Kreps’
example, in contrast, firms have equal costs.
What Kreps’ monopolist is trying to do is take advantage of its first-mover advantage to make output so
high that an entrant would be unable to cover its costs.
6. Kreps adds, “Now rather a lot is wrong with the story just told...”
True, False, and Explain: The monopolist’s story might be OK in a repeated game IF there are also sunk costs.
FALSE. The monopolist’s story can work with repeated
play OR sunk costs; either one is enough.
With repeated play, a monopolist might endure losses in the hope of
deterring future entry. With sunk costs,
the monopolist’s first-mover advantage would be stronger – once it locks in its
quantity, the entrant would know for sure that it would lose money (rather than
convincing the monopolist to reduce its output to accommodate the entrant).
7. Suppose two players play the following normal
form N times. N
is finite and known by both players.
|
Left |
Right |
Left |
5,1 |
0,0 |
Right |
0,0 |
1,5 |
True, False, and Explain: Alternating back and forth between (L,L)
and (R,R) is an equilibrium as long as N is
even and β≥5/6.
FALSE. This is an equilibrium for all N and all β. Whenever a firm defects from it, it gets 0
instead of 1 or 5, so there’s never any point in deviating.
8. Consider a Cournot model with two firms. P=10-Q, and MC=0.
True, False, and Explain: If one firm moves first, the unique SGPNE has a higher Q than it does with simultaneous play.
TRUE. Applying subgame perfection, let’s start with
the second mover. It maximizes:
, implying:
, so
In
a SGPNE, the first mover takes the second-mover’s reaction function into
account. This means that it substitute’s
firm 2’s reaction function into it’s own profit function before taking the derivative:
. This simplifies to:
. Maximizing wrt gives us:
, so . Now plug into firm 2’s reaction function to
get:
. Since Cournot output
is: , output rises.
BTW,
you may already be familiar with this problem as the “Stackelberg model.”
9. True, False, and Explain: The
War/Peace game confirms the view that the invention of atomic weapons reduced
the risks of war and human extinction.
FALSE. In the MSNE, the probability of playing War
falls as the (War, War) payoff gets more negative; and since the probability
that (War, War) happens is that [P(War)]2, the risk of war goes
down. However, the probability of human
extinction still probably goes up – nukes make war less likely, but much more
devastating if it does happen.
Part 2: Short Answer
(20 points each)
In 4-6 sentences AND/OR equations, answer all three of the following questions.
1. People
occasionally argue that Western consumers are virtually “satiated” – before
long, they will have everything they want.
Assume this claim is correct, and that labor productivity continues to
improve. Describe the general
equilibrium consequences for output, employment, wages, and real interest
rates. Carefully explain your reasoning.
What
happens:
Output: Output continues to rise slightly as labor productivity keeps going up, approaching but
never reaching the satiation level. If
output hit satiation, people would stop working; but otherwise the tendency of
greater productivity to raise output remains.
Employment and wages: Increasing labor productivity raises labor demand, and
as workers approach satiation, their labor supply curve starts to bend
backwards. The result: Wages go up, but
employment declines as satiated high-wage workers switch from labor to leisure.
Real Interest Rates: As the intertemporal GE consumption model at the end
of the Week 2 notes explains, positive time preference (β<1) and growing income (g>0) guarantee a
positive real interest rate. Since the
question says, “Labor productivity continues
to improve,” there is no reason to say that real interest rates rise; all we
can say is that they remain positive.
Note: The question says “virtually satiated,” not “completely satiated”; furthermore,
nothing in the question suggests that consumers would remain satiated if there
were a drastic fall in output. It is
incorrect, then, to claim that output and employment would fall to zero. Even if this were so, though, wages would
still go up, because in GE workers earn their marginal product.
Furthermore,
no matter what happens to output, there’s no reason to think that real interest
rates would fall. If labor productivity is rising, workers who
feel almost satiated today should expect to feel even more satiated next year, so interest rates would still be positive!
2. People
(including economists) often think that monopolies are productively
inefficient. Why, on reflection, would
this be strange? What additional
assumptions do you need to make the “inefficient monopolies” story internally
consistent?
It
would be strange for monopolies to be productively inefficient because regardless of how little competition a firm
faces, higher costs imply lower profits.
Even a monopoly totally protected by the government should still want to
minimize costs; otherwise it’s just leaving money on the table. (Many students mentioned potential
competition, but that misses this much more fundamental point).
Two
good stories about productively inefficient monopoly:
a.
Firms have a range of levels of productive efficiency, and the government
decides to legally protect a firm that is NOT the most efficient. This could be because the firm best at
lobbying the government for help is not the best at actually producing the
product.
b.
The firm is a monopoly with regulated profits.
This gives it an incentive to eliminate the “excess” profits by letting
costs rise, rather than cutting prices.
Remember the “gold-plating effect”?
3. If Landsburg’s “People Wanted,” (Fair Play) is correct, does Kaldor-Hicks efficiency require the long-run maximization of population? Carefully explain your answer, staying as close as possible to Landsburg’s descriptive claims about the economic consequences of population growth.
Kaldor-Hicks
efficiency does NOT require population maximization. Landsburg points to important positive
externalities of child creation. However,
positive externalities of X do not imply the efficiency of maximizing X! (By analogy, the negative externalities of
pollution do not imply the efficiency of a total ban).
In
the absence of natalist subsidies,
Landsburg thinks that every child is more than worth its social cost (except,
he notes, for criminals, welfare recipients, etc.) In his view:
Benefit
to Society > Benefit to the Family ³ Cost to the Family »
Cost to Society
As
you pile on the subsidies, though, the marginal cost to families of caring for
more children go up. Eventually you
reach the point where the cost to the family of creating another person exceed
the benefit to society. There’s no
reason to think this point is equivalent to “long-run maximum population.”
You
could also argue that eventually population has negative externalities – not
“resource depletion” (as Landsburg explains, that’s doesn’t count), but on e.g.
air pollution, congestion, or other uncharged impositions upon your fellow man.
The conclusion that K-H efficiency does not imply population maximization is clearly true if you don’t count unconceived people’s “willingness to pay to be conceived.” Even if you did, though, K-H still might not imply population maximization. Consider: If you already felt completely exhausted taking care of 9 kids, the 10th kid might have to pay you more than his discounted lifetime earnings to induce you to have him, so the cost of his conception exceeds the benefit.