Economics 849 Midterm

Prof. Bryan Caplan

Fall, 2004

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.  In 2-3 sentences (and clearly-labeled diagrams, when helpful), explain why.

1.  Most textbook treatments of public goods define them as goods that are non-exclusive and/or non-rival.

T, F, and Explain:  Caplan's definition of public goods drops non-rivalry because there is nothing inefficient about non-rivalry.

FALSE.  Caplan does drop non-rivalry, but his rationale is that many of the goods we normally consider private (such as matinees) are non-rival – that is, have a MC=0.  Non-rivalry does lead to (modest) inefficiency if P>0, but it is more illuminating to see this problem as just a form of monopoly.

2. Suppose that there are 25,000,000 voters other than yourself.  There is a 99% chance that the electorate is not evenly divided.  In that case, p=.51.  But there is a 1% chance that the electorate is evenly divided (p=.5).  It takes you \$10 worth of time to vote, and the present value of your wealth is \$1,000,000 higher if your preferred candidate wins.

T, F, and Explain:  As usual, in this example it is selfishly optimal not to vote.

TRUE.  You can copy the probability of decisiveness calculation off last year's midterm:

The probability of casting a decisive vote is given by:

This simplifies to:

Then simply note that \$1,000,000/626,657=\$1.60<\$10.00.

3. Suppose the supply of labor is perfectly inelastic.

T, F, and Explain:  The Laffer curve never turns down, but the Ramsey rule does not necessarily recommend a 100% tax rate.

TRUE.  If labor is perfectly inelastic, its quantity is fixed, so no matter how high taxes get, the amount of revenue is directly proportional to the tax rate.  However, the Ramsey rule tells you to minimize the deadweight cost of raising a GIVEN amount of revenue, not to maximize revenue, so you would not necessarily want a 100% tax.

A couple of students noted that the Ramsey rule refers to demand elasticities.  This is not true generally, but I did say it for the simplified version in the notes, so I gave credit for this answer.

4. Suppose supply and demand are given by the following:

(S)       Q=a+bP

(D)       Q=c-dP

T, F, and Explain:  If b is infinite and d is zero, it will be impossible for a government to raise any revenue by taxing this market.

FALSE.  Supply is perfectly elastic, but demand is perfectly inelastic, so any tax will be born 100% by demanders.

5.  T, F, and Explain:  For Cooter, agenda setting is the most fundamental way to avoid political cycling.

FALSE.  On p.47 of the hardback version of Cooter, he specifically states that "Political bargaining is the most fundamental means to avoid voting intransitivity."

6.  Popular stereotypes say that high income people have more political information.  But Delli Carpini and Keeter's Table 4.1 reports that, ceteris paribus, income has little effect on political knowledge.

T, F, and Explain:  Delli Carpini and Keeter eventually provide a simple explanation for why the data seem to contradict the stereotype.

TRUE.  As they explain on pp.199-200, income does predict political knowledge if you do not control for other variables.  But income correlates with other variables, most notably education, and in a multiple regression, it turns out that education, not income, does most of the work.

Part 2: Short Essays

(20 points each)

In 6-8 sentences, answer all of the following questions.

1.  Analyze the incidence of the recent award of the Nobel prize to Kydland and Prescott.  Be sure to mention the most important elasticities, and why you think they are high or low.

Kydland and Prescott are highly inelastic – there is no easy way to clone them.  So they are, as expected, the main beneficiaries of the prize.  They will probably not have to share much of their prize with anyone else – the prices of the goods they consume will not change much, if at all, because of their newfound wealth.  K-P students are also fairly inelastic in supply, and they probably will see a rise in demand for their services, so they benefit too.  Other scholars who take K-P's approach to macroeconomics probably see some gain, but because new entry is possible, their gain will be smaller.  Since the Nobel is unlikely to be awarded to anyone who made major contributions similar to K-P's, and since comparable senior scholars are also inelastically supplied, their Nobel may actually make their closest competitors worse off!

2.  Suppose voters' preferences toward abortion can be represented on a 0-1 scale, with a=0 indicating "no regulation" and a=1 indicating "absolute ban."  If voters were fully informed, 60% would have a=.25 and 40% would have a=.75.  But in fact, all voters are poorly informed.  50% of the time, their expressed preference equals their fully informed preference plus .25; 50% of the time, their expressed preference equals their fully informed preference minus .25.  Does the Miracle of Aggregation work in this example?  Why or why not?

The Miracle of Aggregation does NOT work!  The median preference with full information is a=.25, because 60% of the public wants exactly that.  But the median preference with poor information changes in the following way:

30% think they want a=0.

(30+20)=50% think they want a=.5.

20% think they want a=1.

The actual median is therefore .5, not .25 as it would be with full info.

There are two weird features of this example, and both explain why the usual analysis fails.  First,  the preference distribution and the errors are discrete.  Continuity of some kind must be a tacit assumption of the usual analysis.  Second, the preference distribution is bimodal.  The usual analysis must require stronger distributional assumptions than the typical defender of the Miracle lets on.

3.  If economic conditions in an urban area get worse, higher-income residents are more likely to leave.  Explain how could this give incumbent politicians perverse incentives.  Which of the following would be the most effective way to mitigate this problem: (1) political bargaining; (2) term limits; (3) limits on campaign contributions?  Justify your answer.

If an incumbent is more popular with poor than with rich residents, he might try to induce the migration of his opponents with counter-productive redistribution.  It just might make his re-election campaign easier because he will face a more sympathetic median voter.  In my opinion, term limits are the best solution to this problem (though there were other well-argued answers) – if an incumbent cannot be re-elected anyway, he has little incentive to try to change the identity of the median voter of the future.  True, he might seek higher office, but that probably gives him a reason to build a reputation for getting along with rich and poor alike.