1. A monopoly has a fixed cost of 8, a marginal cost of 2, and its pollution imposes costs of 12 per unit of output on residents of its city. Market demand for its product is Q= 48-2P.
(a) (0, 5, 10 points) What is the unregulated output?
Answer. Let P = 24-Q/2. Then profit is Q(24-Q/2-2) - 8. This is maximized if 24- Q-2 =0, so Q=22.
You ccould also answer this question (and part c) by equating marginal revenue and marginal cost.
(b) (0, 5, 10 points) What output maximizes total surplus?
Answer. Let P =14. Then Q = 48-28 = 20.
(c) (0, 5, 10 points) What tax or subsidy would result in the monopoly producing the surplus- maximizing output?
Answer. Profit is Q(24-Q/2-2-tax) - 8. This is maximized if 24-Q-2 -tax=0, so Q=22 - tax. Thus, the tax should be 2 per unit.
The usual optimal tax equals the size of the externality, but that is only for a competitive market. Here, output starts out small to begin with, because of monopoly output restrict, so the tax should be smaller. A tax of 12 on the monopolist would result in output of 8, much smaller than the optimal level of 20.
When the Journal of Economic Literature asked me to write a review of The World is Flat, by Thomas Friedman, I responded with enthusiasm, knowing it wouldn’t take much effort on my part. As soon as I received a copy of the book, I shipped it overnight by UPS to India to have the work done. I was promised a one-day turn-around for a fee of $100. Here is what I received by e- mail the next day: “This book is truly marvelous. It will surely change the course of human history.” That struck me as possibly accurate but a bit too short and too generic to make the JEL happy, and I decided, with great disappointment, to do the work myself. ...Answer. The Leamer paper continues thus:Commenting on outsourcing, Chairman Mankiw, in the Economic Report of the President, 2004, advises:
“When a good or service is produced more cheaply abroad, it makes more sense to import it than to make or provide it domestically.”
But, based apparently on some serious late-night library work, Schumer and Roberts reply in the New York Times
“when Ricardo said that free trade would produce shared gains for all nations, he assumed that the resources used to produce goods -- what he called the ''factors of production'' -- would not be easily moved over international borders. Comparative advantage is undermined if the factors of production can relocate to wherever they are most productive: in today's case, to a relatively few countries with abundant cheap labor. In this situation, there are no longer shared gains -- some countries win and others lose.”
“And one thing is certain: real and effective solutions will emerge only when economists and policymakers end the confusion between the free flow of goods and the free flow of factors of production.”My first reaction to Schumer and Roberts was: You need to write on the blackboard 100 times: “There are gains from exchange.” Ricardo’s (1817) Principles of Political Economy and Taxation was a good start, but take a look at the book that got Ricardo thinking about the issues: Adam Smith’s (1776) An Inquiry into the Nature and Causes of the Wealth of Nations. It was Adam Smith who emphasized the gains from exchange and the division of labor: "The propensity to truck, barter and exchange one thing for another is common to all men, and to be found in no other race of animals." It is the opportunity to exchange that allows the division of labor, from which flow the incredible efficiencies characteristic of modern economies. ("A Flat World, A Level Playing Field, a Small World After All, or None of the Above? Review of Thomas L. Friedman, The World is Flat. by Edward E. Leamer, April 16, 2006)
The very fact that there is an exchange confirms that there are gains. When ownership freely passed from seller to buyer, the product or service increases in value, passing from one who values it less to one who values it more. The gains from exchange occur when buyer and seller reside in the same country, and occur likewise when buyer and seller reside in different countries. Location of residence of buyer and seller is utterly irrelevant.Thus, the answer is very simple. If there is no market failure, trade increases surplus, and where the inputs are located is irrelevant to that.
3. At the end of the test is an article on the Erbitux anti-cancer drug's approval.
(a) (0,5,10 points) How does Erbitux illustrate Type I and Type II error?
Answer. The FDA made a Type I error, a false rejection of Erbitux. This is apparent because it later changed its mind. A Type II error is a false acceptance, which it wanted to avoid.
(b)(0,5,10 points) Why is the FDA likely to approve too few drugs rather than too many?
Answer. From National Review Online, May 1:
[F]ormer FDA Commissioner Alexander Schmidt: "In all our FDA history, we are unable to find a single instance where a Congressional committee investigated the failure of FDA to approve a new drug. But the times when hearings have been held to criticize our approval of a new drug have been so frequent that we have not been able to count them. The message to FDA staff could not be clearer."
(c)(0,5,10 points) Should the FDA be required to approve a prescription drug at all, since uninformed patients cannot use them without a prescription? If not, do you think the FDA should be abolished?
Answer. The argument would be that drug companies can fool doctors into prescribing unsafe and ineffective drugs, perhaps because unscrupulous doctors would take advantage of their patients despite malpractice laws. This is a somewhat weak argument. The argument for requiring approval of *non*- prescription drugs is much stronger, since patients are less intelligent and well-informed than doctors, and do not have the reputation incentive. One might also argue that the FDA should test drugs, to improve information, but not require that drugs pass through an approval process before doctors can prescribe them.
It is not a good answer to say that doctors do not have the time to test drugs themselves. Without the FDA, the drug companies would still have to convince doctors to prescribe new drugs instead of using the old drugs. The companies could do exactly the same studies that they do for FDA approval now, if that was what doctors wanted to see. Doctors are not stupid; they would not rely on the unsubstantiated claims of drug salesmen. Doctors have strong incentives to prescribe medicines that work and few (if any) incentives to prescribe medicines that do not work, and they have the expertise to figure out which ones work.
A distressingly large number of students thought that doctors could not be trusted to make accurate medical judgements about drugs. Please note that doctors and drugs are no different, in principle, than computer technicians and computer models or any other industry where profit-maximizing managers must choose which new products to adopt. Yet we do not think that the government has to protect computer technicians from possibly ineffective new computer models because the technicians are too pressured by computer salesmen, or fooled by them into accepting low-quality products.
Note, too, that if doctors are really that stupid, then we should expect a massive amount of malpractice due to pressure from drug company salesmen. Rather than ever operate on cancer, for example, the foolish doctors would prescribe whichever of the many FDA-approved drugs available was suggested by the most recent salesmen who had called.
(d) (0,5,10 points) How would FDA behavior change if patients were allowed to sue the FDA for mistakes in the approval process?
Answer. The FDA would then have to worry more about both kinds of errors--- false rejections and false approvals--- and the negative consequences of false rejections would rise more than those of false approvals. Whenever the FDA failed to approve a new drug that someone could prove safe and effective in court, the FDA would have to pay damages to all the patients who could have used that drug. Currently, the number and losses to such patients seems to be far higher than the number and losses to patients who have been hurt by taking new approved drugs.
It was surprising how many students failed to notice that the lawsuits would penalize not just false approvals but false rejections.
It is not a good answer here to say that false rejections are less visible than false approvals. That is why the political process is imbalanced, but that kind of visibility does not matter to lawsuits. For a lawsuit, what matters is whether a lawyer can identify the mistake and organize a class-action lawsuit, not whether large numbers of voters notice.
Also, note that the question asks what would happen *compared to the present situation*, which is heavily skewed towards avoiding false approvals. The FDA would, of course, start worrying about lawsuits from false approvals, as well as about the heavy political fallout. But it would also start worrying about lawsuits from false rejections, and now it has little concern about political fallout from false rejections. The net result would be more balance (though an unhappier FDA).
It was not part of the question, but one reason allowing such lawsuits might nonetheless be bad policy is that it would result in high legal costs.
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*4. (0,10,20, 30 points) Suppose that we observe that the market wage for store clerks in a town is $8/hour, and that at this wage the quantity supplied equals the quantity demanded. Explain why the wage is $8 per hour, no higher and no lower.
Answer. If the wage were higher, then more people would want to be clerks than there were jobs to fill. Stories, realizing that, would cut their wages and still be able to fill all their positions, so the higher wage would not continue to be paid. If the wage were lower, more stores would want clerks than there were workers available. A store that could not get a clerk at the low wage would raise it so as to attract a clerk, so the low wage would not continue to be offered.
This is essentially the same question as on one of the midterms. As explained in the answer sheet there, it is *not* a correct answer to say that the wage is $8 because that maximize surplus, is optimal, etc. Many things in the world would be nice to have, but don't actually work out that way. Surplus maximization happens to be a consequence of $8 being the wage, but it is not the cause of the wage being $8.
5. Give short answers to each of these questions.
*(a) (0, 5, 10 points) Say what the two main antitrust laws are, and give one example apiece of behavior they prohibit.
Answer. Sherman Act--- price-fixing. Clayton Act--- monopolizing mergers.
*(b) (0, 5, 10 points) Lobbying can result in government failure. Explain how lobbying sometimes prevents government failure.
Answer. Lobbying can inform the government when it is doing something stupid because of lack of knowledge of the situation.
(c) (0, 5, 10 points) How can regression analysis be used to test whether OSHA has reduced workplace injuries?
Answer. Regress annual injuries on time, a dummy for the years OSHA existed, and an interaction between the OSHA dummy and time. Just regressing injuries on a dummy for OSHA would be a bad test, because injuries have been falling over time anyway.
*(d) (0, 5, 10 points) Suppose a market currently has a Herfindahl Index of 1,000, and two firms with market shares of 5% and 9% want to merge. What would the post- merger Herfindahl index be? Would the Justice Department try to block the merger?
Answer. Currently these two companies contribute 5*5+9*9 =106 to the Index. After merger, they would contribute 14*14= 196. An increase in 90 (less than 100) starting from 1000 would be too little for Justice to want to block the merger.
*(e) (0, 5, 10 points) Give an example showing how two people would both be better off as a result of regulation restricting the liberty of each.
Answer. I was impressed with the quality and variety of answers people gave. One example is that two people might both be willing to be forced to drive less than 100 m.p.h. because each fears the fast driving of the other more than he likes driving fast himself.
* (f) (0, 5, 10 points) What is the function of the Office of Management and the Budget as far as regulations are concerned?
Answer. The OMB reviews new regulations before and after the public comment period, and can block bad regulations.
*(g) (0, 5, 10 points) Explain why the tiny country of Monaco has more reason to legalize gambling than the large country of France.
Answer. Monaco gets the benefits of gambling (taxes, etc.), but most of the cost falls on neighboring France, and other countries whose citizens go to Monaco to gamble.
It is a bad answer to say that small countries need new industries more. There is no particular reason why a small country would be poorer or less developed than a large country.
6. (0,10,15, 20 points) Show using graphs how it is possible that a natural monopoly which is currently required to charge a price equal to marginal cost, with a subsidy that only slightly exceeds its loss from charging a price less than average cost, might prefer the status quo to either (a) rate of return regulation, under which it is allowed to charge a price equalling average cost, or (b) complete deregulation, so it is allowed to charge any price it desires.
Answer. The firm is currently earning a small positive profit. Under rate of
return regulation, it would lose the subsidy and earn at most a zero profit. If
demand is weak enough, in fact, it would earn a negative profit no matter how
high a price it was allowed to charge. Similarly, if demand is weak, then even
under complete deregulation-- and monopoly pricing-- it would have negative
profits.
Drug Reckoning A cancer drug proves its usefulness. Will the FDA now do the same?
Monday, March 6, 2006 12:01 a.m. EST
In the wake of last year's Vioxx panic, it would be easy to imagine that unexpected news about new drugs will be mostly bad. But two stories last week remind us why that's not the case, and that an excess of caution--whether due to regulation, litigation or fear--can itself be harmful to public health.
The first story concerns Erbitux, the ImClone cancer drug that became infamous after its initial rejection by the Food and Drug Administration in December 2001 led to an insider trading scandal that counted Martha Stewart as a victim. We said from the start that the FDA had made a bad call, and Erbitux was eventually approved to treat colon cancer.
Well, it turns out Erbitux works for other cancers too. Last Wednesday the FDA approved the drug for a new indication--head and neck cancer--based on data showing a whopping 20-month survival advantage over traditional chemotherapy alone. In fact, Erbitux represents the first significant advance for head and neck tumors since the 1950s.
That Erbitux worked in head and neck tumors was fairly obvious from early trial results even at the time it was first rejected for colon cancer. Dr. Mark Thornton, one of the FDA medical reviewers who finally helped push Erbitux through in 2004, tells us there was "extremely compelling" data on Erbitux for head and neck cancer as early as 2000. He adds that "it was hard to argue against providing it to patients" at the time it was first rejected.
Another man for whom the latest news on Erbitux is bittersweet is Frank Burroughs, who founded the Abigail Alliance for Better Access to Developmental Drugs in honor of his daughter, who died of head and neck cancer while trying to obtain Erbitux and other treatments. "This news serves as yet another reminder that the biggest 'ImClone scandal' of 2001 had nothing to do with Martha Stewart, but instead resulted from the FDA's failure to approve a drug that had been proven safe and effective for thousands of patients," the Alliance said in a statement.
In short, Erbitux is a perfect example of why it's important to get active drugs with reasonable safety profiles out before all the efficacy data is refined to the 10th decimal place, as the FDA always tries to insist. Such data are never going to be complete anyway. Think of all the new benefits that still keep being discovered for humble aspirin.
The second good-news story last week concerns Tysabri, the multiple sclerosis treatment that was voluntarily withdrawn last year (read: lawsuit panic) after three patients on the drug developed a rare neurological infection. This possible side effect wasn't entirely surprising, given that MS is a degenerative neurological disorder caused by immune system dysfunction and Tysabri works by depressing parts of the immune system. But it was also clear, as we editorialized at the time, that the patients in question had been treated with other immuno-suppressive drugs too, and that the risks of untreated or poorly treated MS probably outweighed the risks of taking Tysabri.
Well, now several new studies reported in the New England Journal of Medicine appear to support the point that Tysabri's risks are small and its potential benefits big. Tysabri appears to cut the rate of clinical relapses by 68%, and reduce by a whopping 83% the number of new or expanding brain lesions found in MS patients.
And remember that since MS is a degenerative disease there's no way to undo the damage in patients denied the right to weigh Tysabri's risks and benefits for themselves. This week an FDA panel will meet to consider Tysabri's re- introduction to the market and MS patients are expected to be there in force. "This drug worked for me, and I want to be able to have the choice to make an informed decision," said Cheryl Bloom, who also told Bloomberg news service she will be paying her own travel expenses from Idaho to have her voice heard.
A common theme in the story of these two different drugs is the issue of informed consent. Our philosophy is that patients and doctors dealing with fatal or degenerative diseases ought to have the maximum possible autonomy in treatment decisions. We now know that the FDA could have extended a lot of lives had it followed that principle with Erbitux from the start. And it has an opportunity to extend and improve many more if it decides to help facilitate Tysabri's return to the market.