Economics
812 Midterm Answer Key
Prof.
Bryan Caplan
Spring,
2016
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 six propositions is true or false. Using 23 sentences AND/OR equations, explain your answer.
1. Suppose all the assumptions of the First Welfare Theorem are true.
True, False, and Explain: Markets are Pareto and KaldorHicks efficient.
TRUE. The First Welfare Theorem assumes no
externalities, perfect information, and an exogenous price vector, and proves
markets are Pareto efficient. Given
these assumptions, moreover, people sell ANYTHING they possess that ANYONE else
values more highly than they do, so markets maximize total surplus and are therefore
KH efficient.
Most
students answered FALSE, citing the notes on the fact that Pareto efficiency
does not imply KH efficiency. This
is true in the real world, but the assumptions of the First Welfare Theorem are
so unrealistic that both Pareto and KH efficiency follow!
2. Suppose 45% of all agents in an economy have U=ln x + ln y, and the other 55% have U=.75 ln x + .25 ln y. All agents start with one unit of x and two units of y.
True, False, and Explain: In general equilibrium, exactly 55% of the agents consume more y than x.
FALSE. 100% of agents consume more y than
x. To see this, first calculate the
equilibrium price vector:
This implies all agents have income of 1*3.52+2*1=5.52. Type 1 agents spend 50% of this income on x, 50% on y, so they consume 5.52*.5/3.52=.784 x and 5.52*.5/1=2.76 y, so y>x for them. Type 2 agents spend 75% of their income on x, 25% on y, so they consume 5.52*.75/3.52=1.18 x and 5.52*.25/1=1.38 y, so y>x for them too.
3. Suppose that two players play the following three games in order: Coordination game, Prisoners' Dilemma, Ultimatum game.
True, False, and Explain: Standard game theory predicts that this game will completely
"unravel."
TRUE. “Unraveling” means players
play each stage of the game as if it were not repeated. The last stage – the Ultimatum
game – has only one SGPNE, where Player 1 offers $.01 and keeps the rest
for himself, and Player 2 accepts.
As a result, standard game theory says players cannot use punishments to
avoid the standard (Defect, Defect) outcome in the PD stage. This in turn implies that players treat
the first stage – the Coordination game – as if it were a oneshot
game. Hence, complete unraveling.
4. “But once you’re in the theater, the owner has a lot of monopolies. He is the only supplier of rest rooms, for example. Why doesn’t he charge you a monopoly price to use them? (Landsburg, The Armchair Economist)
True, False, and Explain: Landsburg concludes that customer diversity, not supplier monopoly, explains why popcorn costs more at movies.
FALSE. Landsburg concludes you need BOTH diversity AND some degree of monopoly (i.e., imperfect competition): “Price discrimination can only work when the seller has a monopoly of the appropriate kind.” Monopoly without diversity leads to high ticket prices and MC pricing for popcorn and other extras. Diversity without monopoly leads to MC pricing for everything.
5. 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<1.
FALSE. Alternating back and forth is ALWAYS an
equilibrium. Defecting reduces your
payoff from 5 or 1 to 0, so there is no temptation to “cheat”
regardless of number of turns or discount rate.
6. Consider a Cournot model with two firms. P=20Q, 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. With simultaneous play, the Cournot notes
tell us market output is 2/3*20=13.3.
With sequential play, player 2 sets q2=(20q1)/2, so player 1 maximizes
Pq1=(20q1(20q1)/2)q1.
Differentiating implies 10q1=0, so q1=10, and q2=(2010)/2=5. So q1+q2=15<13.3.
Part 2: Short Answer
(20 points each)
In 46 sentences AND/OR equations, answer all three of the following questions.
1. Construct a “secondbest” efficiency defense of ONE
existing policy you consider highly inefficient in a “firstbest”
sense. Be as convincing as
possible.
Under
current U.S. law, extremely rare, highly unpopular religions like Satanism are
legal. This seems highly
inefficient in a firstbest sense: the total willingness of religious people to
pay to ban Satanism probably vastly exceeds the totally willingness of
Satanists to pay to keep their religion legal. However, politically drawing the line
between religions like Satanism and moderately unpopular religions like
Scientology is extremely contentious, and risks banning religions that DO pass
the costbenefit test because their followers love them and they only mildly
annoy the majority. These costs and
risks make acrosstheboard religious toleration a secondbest optimum: While
we have to tolerate a few inefficient religions, we avoid religious conflict and
“false positives.”
2. “[I]t seems that the
basic textbook commentary on bilateral monopoly and bargaining had it
right.” (Kreps, A Course in
Microeconomic Theory) Carefully explain (a) what Kreps is
claiming here, and (b) why he claims it.
Does a MSNE view of bargaining lead to a different conclusion?
Kreps is claiming that, according to standard textbook treatments, “bargaining outcomes depend on individual’s expectations as to what the outcomes should be”; furthermore, such expectations can be “manipulated.” He claims this because experiments show precisely this: Playing bargaining games with computers that demand 20% of the surplus subsequently leads human beings to bargain harder with other humans than playing bargaining games with computers that demand 50% of the surplus. The MSNE view leads to a somewhat different conclusion: While expectations do matter, some expectations are not stable. In particular, if people expect too much, lowering your expectations leads to higher payoffs – and if people expect too little, raising expectations leads to higher payoffs.
3. What is the most empirically relevant model our class has studied so far? The least empirically relevant model? Justify both answers.
The
reputation model is the most empirically relevant. Reputation makes the business world go
round, especially in the internet age of ubiquitous product reviews and
ratings. Businesses can almost
always raise their SHORTRUN profits by cutting corners today, but refrain from
doing so because this destroys their LONGRUN profits.
The ultimatum game model is the least empirically relevant. It clearly predicts something that essentially NEVER occurs: offering people in disadvantageous bargaining positions an amount vanishingly close to zero. Instead, human beings in such situations gravitate toward even splits.