G406 Test I, Spring 2006 ANSWERS (15 February 2005)


This is an open book, open note test. There are 120 points in total. The grade will be curved.


1. (20) Give short answers to each of these questions.

(a) (0, 2, 5) Explain how a merger might both reduce costs and raise prices.

Answer. The merger might reduce costs by allowing the firms to reduce overhead, merging their fixed costs. At the same time, the firms' increased market power would allow them to raise the price.

(b) (0, 2, 5) Where would the OMB enter the process of making new regulations for the safety of carseats for children?

Answer. The OMB must review new regulations that agencies such as the Dept. of Transportation write, both before and after the public comment period.

(c) (0, 2, 5) Suppose a market currently has a Herfindahl Index of 1,500, and two firms with market shares of 5% and 7% want to merge. What would the post-merger Herfindahl index be? Would the Justice Department try to block the merger?

Answer. Those two firms added 5*5 + 7*7 = 25 + 49 = 74 to the Index before, and after would add 12*12 = 144 to it. That increase of 70 is less than 100, so under the Merger Guidelines for an industry with an Index of 1570 it would be unlikely to be challenged.

(d) (0, 2, 5) Suppose cartel agreements were legally enforceable, as they once were in Germany. Why might it still be difficult to form a cartel?

Answer. Firms still have to agree to the cartel contract, and some of them might try to stay out and be free riders on the high prices that result from the cartel. Also, cheating may be possible even if the cartel is a legal agreement.


2. (20) (0, 5, 10,15, 20) Why is the market price at the intersection of the supply and demand curves, no higher and no lower? Explain the economic process --- do not simply say something like "Otherwise there would be excess demand."

Answer. If the price were higher, then some sellers who wanted to sell at that price could not find customers, and so would be willing to reduce their prices slightly, driving down the market price. If the price were lower than the intersection price, some buyers who wanted to buy at that low price could not find sellers, and a seller could raise his price and still find customers. Thus, a price below the intersection price would not be stable either.


3. (30) Suppose demand for cola is given by the equation P = 48 - 2Q, where Q is the market quantity and P is the market price, and suppose that the fixed cost for a company to make cola is 8 and the marginal cost is zero.

(a) (0, 5, 10) Suppose the market contains two firms, and they simultaneously choose their outputs. What outputs will each of them choose, and what price will result? Denote one firm's output by A and the other's by B.

Answer. Firm A's profit function will be (48- 2A - 2B)A - 8. Differentiating yields 48 -4A - 2B = 0, so the reaction function is A = 12- B/2. Since B solves a similar problem, A=B, so A = 12 - A/2, and 3A = 24, so A=8. Total output will be Q=16, so P = 48 - 2(8+8) = 16.

(b)(0, 5, 10) If the two firms merge, what will be the price and output?

Answer. The profit function will be (48-2Q)Q - 8. Differentiating yields 48AQ - 4Q =0, so Q=12, in which case P = 24.

(c) (0, 5, 10) What would be the value-maximizing price, and the smallest output that maximizes value?

Answer. The value-maximizing price equals marginal cost, which happens to equal zero here. P = MC= 0, so Q = 24.


4. (30) Look at the clipping, "China antitrust law worries foreign interests" at the end of this test.

(a) (0, 5, 10) Why do foreign companies fear the new Chinese anti-trust law?

Answer. They are afraid that it might be used to discriminate against foreign firms, and, in particular, that it might be used to attack patent monopolies and require some sort of compulsory licensing.

(b) (0, 5, 10) Why does the possibility of government failure cast doubt on whether antitrust law is a good idea for China?

Answer. There are many government-owned companies in China. The antitrust law might be used to help those companies compete against private companies, since the government might put the profits of its own companies ahead of those of competitors or ahead of consumer surplus.

(b) (0, 5, 10) How might the new antitrust law actually reduce problems caused by government failure in China?

Answer. It might help by allowing the central government to stop local governments from protecting local companies, restricting entry or otherwise increasing market power. Also, it would help the central government to control the behavior of locally-owned government companies that might be favored by local governments. Note that it would *not* help by increasing protection of intellectual property--- the antitrust laws would not do that in any way.


5. (20) Consider the situation described in the clipping, "Weighing the True Costs and Benefits" at the end of this test.

(a) (0, 3, 5) Make the value maximization argument for turning off Miss Habtegiris's ventilator.

Answer. Landsburg's argument is that her benefit from the ventilator, as measured by her willingness to pay, is less than the cost to the hospital. Not only is she unwilling to pay the cost (perhaps because she is too poor to do so) but it seems unlikely that before knowing for sure whether she would become sick she would have preferred ventilator insurance to the cash value of ventilator insurance.

(b) (0, 3, 5) Make the value maximization argument for *not* turning off Miss Habtegiris's ventilator.

Answer. Frank, the author of the article, says that the argument in (a) neglects the benefit to the rest of the people in America of keeping the ventilator on. Even if Miss Habtegiris would not have bought insurance, maybe the rest of us feel sorry enough for her in this situation that we each would be willing to chip in a little to pay for her ventilator, and the sum of these contributions would exceed the cost to the hospital.

It is not a value-maximizing argument to say that the ventilator should be kept on because it is important to Miss Habtegiris. Value maximization uses people's willingness to pay to indicate value, and Landsburg's argument in (a) is precisely that thus measured, she would rather have the money than the ventilator.

One argument that might be made (though nobody did on the test) is that even though Miss Habtegiris was unwilling to pay, say, $50,000 for the ventilator because of her poverty, if she was offered a choice between a gift of the ventilator and a gift of $50,000, she would have taken the ventilator. This is the "willingness to pay vs. willingness to accept" puzzle, well-known to economists. It is not clear she would rather have the $50,000, though--- being so poor, she might well prefer to give her family that large amount of money rather than give them a chance to see her once more.

(c) (0, 3, 5) The clipping does not say whether Miss Habtegiris's family could have paid the amount needed to keep her alive until her mother flew in from Africa. Suppose they did have the money, but refused to pay it. How would that affect the cost-benefit decision?

Answer. In itself, that would have no effect-- it would just confirm that, as suggested in (a), that the benefit of the ventilator to herself and her family, as measured by willingness to pay, was low. It might be, however, that other people, who otherwise would feel sorry for her and be willing to pay for her ventilator, would not feel sorry for her if she were able to pay. If that were the case, then the benefit in (c) would disappear, and the ventilator should be turned off.

(d) (0, 3, 5) Suppose Miss Habtegiris's mother could not afford the air fare to fly in from Africa. What would be the effect of a law requiring the Baylor Regional Medical Center to pay for the ticket in such a case? Would such a law be value-maximizing?

Answer. The elements of the analysis are the same as in (a) and (b). If enough strangers were willing to pay for the ticket, then it would be value-maximizing for the ticket to be given to the mother, whether Baylor or the strangers paid. (It might be thought unfair to Baylor to have the hospital pay for what benefits the strangers, but that is a different question.)

The answer is not that this is value-maximizing because it helps Miss Habtegiris's mother. It does, but that ignores the cost.

There is a separate point, though, concerning the incentives for hospitals to accept poor patients. If the hospital must donate ventilator treatment or plane tickets to patients who become very sick, the hospital will be less willing to accept those patients into the hospital in the first place. Even if Medicaid (government health funding for poor people) or the patient pays for the initial treatment, the hospital runs the risk of the condition becoming more serious and the hospital having the bear heavy costs once the patient and Medicaid stop paying.


Weighing the True Costs and Benefits in a Matter of Life and Death

By ROBERT H. FRANK
Published: January 19, 2006

DO the poor deserve life support?" asks the economist Steven E. Landsburg in an article published under that title in Slate this month (www.slate.com/id/2133518/?nav=fo). The subtitle says: "A woman who couldn't pay her bills is unplugged from her ventilator and dies. Is this wrong?" Mr. Landsburg invokes "economic considerations" to suggest that the answer is "no."

Many commentators have attacked his argument as morally preposterous. Well, yes. But it is also economically preposterous. The two judgments are related. But before an attempt at explaining why, here are some details of the case, from the Slate article and the Dallas-Fort Worth television station WFAA:

The patient was Tirhas Habtegiris, a 27-year-old legal immigrant being kept alive by a ventilator as she lay dying of cancer last month in the Baylor Regional Medical Center in Plano, Tex. Physicians offered no prospect for her recovery. She was hoping, however, to hang on until her East African mother could reach her bedside.

Ms. Habtegiris had little money and no health insurance. On Dec. 1, hospital authorities notified her brother that unless another hospital could be found to treat his sister, Baylor would be forced to discontinue care after 10 days. But even with Baylor's assistance, the family was unable to find a willing hospital. True to its word, Baylor disconnected her ventilator on Dec. 12, invoking a law signed in 1999 by George W. Bush, then governor of Texas. The law relieved doctors of an obligation to provide life-sustaining treatment 10 days after having provided formal notice that such treatment was found to be medically "inappropriate."

Unlike the comatose Terri Schiavo, Ms. Habtegiris was fully conscious and responsive when she was disconnected, according to her brother. She wanted to continue breathing. Her brother and several other family members have described the agonizing spectacle of her death by suffocation over the next 16 minutes. Her mother never got there. (Baylor officials have said their decision had nothing to do with financial considerations.)

In Baylor's defense, Mr. Landsburg argues that Ms. Habtegiris's treatment would have failed the economist's basic cost-benefit test, which says that an action should be taken only if its benefit exceeds its cost. The cost of care is relatively easy to calculate, but measuring its benefit is more difficult, and it is here that Mr. Landsburg stumbles.

In general, economists measure the benefit of an action as what its beneficiaries would be willing to pay to see it taken. To place a rough upper bound on the benefit of supporting Ms. Habtegiris, Mr. Landsburg asks us to imagine that before her illness, she had been given a choice between free ventilator insurance and $75 in cash (his illustrative estimate of the cost of providing a healthy young person with such insurance). He assumes, plausibly, that she would have chosen the cash. The implication, he believes, is that the benefit of extending Ms. Habtegiris's care must be less than its cost.

He is mistaken for multiple reasons. For one thing, he ignores the economically compelling reasons for having social safety nets in the first place. Even those who are not poor recognize that catastrophe is only one unlucky break away. One might lose one's job and be unable to afford health insurance, for example, or be stranded by a mountain blizzard and unable to afford a helicopter rescue. With such prospects in mind, most people favor collectively financed rescue efforts. That a poor person would not, or could not, buy private insurance against such contingencies is entirely beside the point.

Even more troubling, Mr. Landsburg completely ignores moral emotions like sympathy and empathy. As economists since Adam Smith have recognized, economic judgments are often tempered by these emotions. The upshot is that large numbers of people benefit when a patient in imminent mortal danger receives treatment. Had the opportunity presented itself, many would have eagerly contributed to Ms. Habtegiris's care. But organizing an endless series of individual private fund-raisers for such cases is impractical. So, we empower government to step in when the need arises.

Mr. Landsburg's argument finesses the important distinction between a "statistical life" and an "identified life." The concepts were introduced by the economist Thomas C. Schelling, who observed the apparent paradox that communities often spend millions of dollars to save the life of a known victim - someone trapped in a mine, for example - yet are often unwilling to spend even $200,000 on a highway guardrail that would save an average of one life each year.

This disparity is not economically irrational, Mr. Schelling insisted, because the community values what it is buying so differently in the two cases. It is one thing to risk one's own life in an unlikely automobile accident, but quite another to abandon a known victim in distress.

By offering a transparently unsound economic argument in defense of the Habtegiris decision, Mr. Landsburg unwittingly empowers those who wrongly insist that costs and benefits have no legitimate role in policy decisions about health and safety. Reducing the small risks we face every day is expensive. The same money could be spent instead on other pressing needs. We cannot think intelligently about these decisions without weighing the relevant costs and benefits.

But using cost-benefit analysis does not make one a moral monster. In the wealthiest nation on earth, a genuine cost-benefit test would never dictate unplugging a fully conscious, responsive patient from life support against her objections. Mr. Landsburg's argument to the contrary is wrongheaded, not just morally, but also economically.

Robert H. Frank, an economist at the Johnson School of Management at Cornell University, is the co-author, with Ben S. Bernanke, of "Principles of Economics." E-mail: rhf3@cornell.edu

Davos 2006: World Economic Forum: China antitrust law worries foreign interests --- Western firms fear policies could target profitable patents By Adam Cohen Dow Jones Newswires 983 words 26 January 2006 The Wall Street Journal Europe

BRUSSELS -- China's long-awaited antimonopoly law probably will create more obstacles to foreign companies' access to its booming economy, people familiar with the law's evolution say.

Western companies' most pressing concern is that the law could allow trumped-up antitrust charges to chip away at their profitable patents. That fear is based on the latest known draft of the law, which prohibits the abuse of intellectual-property rights but doesn't describe how regulators should interpret such offenses. After a decade of discussions, China is expected to put the law into force this year.

More broadly, as the World Economic Forum's annual meeting in Davos, Switzerland, this week focuses on China's emergence, U.S. and European officials and legal experts worry China's tentative moves to open its economy might be rolled back by antitrust policies that protect state-owned monopolies. Since the draft was published in September, a chapter of the law forbidding the abuse of government power to restrict competition has been dropped, according to Wang Xiaoye, a professor at China's Institute of Law and one of the law's drafters.

"There is a lot of uncertainty in this law. I see room to interpret the law in a way that benefits the Chinese in the immediate future," says George Metaxas, a Brussels lawyer who is co-chairman of an International Bar Association group studying the law and advising Beijing.

The fears contrast with earlier hopes that China's antimonopoly law would incorporate Western models and lead to further opening of its economy. Over the past two years, U.S. and European Union officials, lawyers and executives have traveled to China for dozens of meetings and seminars and have sent China comments on multiple drafts of the law.

Some of their advice has made its way into the law, including the section on merger controls, which now outlines clearer requirements and a shorter review process.

Chinese officials say the law has incorporated an unprecedented degree of international advice, but they insist China ultimately must pass a law that is in its own best interests. "China sees a lot of intellectual-property abuses. The Western side might be afraid of its interests being hurt, but there are such provisions in the EU and the U.S., so there is no reason not to allow China to put such a provision in its law," says Yang Wang, an official at the Chinese mission to the EU in Brussels.

"The Chinese feel all the good [intellectual-property] rights have been taken," says Mathew Heim, an antitrust expert at the Centre, a Brussels think tank. "They might use this law to bring down Western companies a notch or two."

That possibility has pushed some of the world's largest patent-holding companies to lobby the Chinese government as the law is being developed. At a meeting last June in Beijing, representatives from Microsoft Corp., Intel Corp., General Electric Co., Cisco Systems Inc., Eastman Kodak Co. and Dow Chemical Co. discussed the law with Chinese officials and academics. According to minutes from the meeting, Microsoft lawyer Yu Weidong described the company as "a major target of this law." A Microsoft spokesman declined to comment on the matter.

In one scenario suggested by Mr. Metaxas, a Chinese company using Microsoft's software could appeal to regulators, claiming licensing fees are hurting its business. The regulator then could rule that Microsoft is abusing its market dominance and force the company to cut its fees or license its technology free. Microsoft and EU regulators are grappling over similar intellectual-property issues, though the EU insists it doesn't want to deprive the company of its property, only to make its systems more compatible with rivals' programs.

Ms. Wang, the China Institute of Law professor, says the country might not be able to deal with such shades of gray. The finer points of antitrust law and intellectual-property rights -- a patent is essentially a legal monopoly -- aren't dealt with in the planned law, and China has almost no expertise in this area, according to Ms. Wang, who is in Chicago on a Fulbright scholarship to study comparative aspects of U.S., EU and German antitrust law.

Political infighting among Chinese agencies is complicating the situation, Ms. Wang says. The chapter forbidding the abuse of government power to restrict competition was dropped during a review of the law by China's State Council, the government's executive arm, before being sent to the National People's Congress for final approval, she says. The chapter would have given Beijing a way to ensure that local governments don't use their powers to favor local businesses at the expense of the next town or province, according to Yee Wah Chin, a lawyer in Washington. Shanghai, for example, might place a tariff on cars made in another city, and the other city will reciprocate.

The government also is divided at the national level on how and whether to overhaul the economy. According to a U.S. official familiar with China's economic reforms, the draft antitrust law has led to a turf war between the Ministry of Commerce and the more conservative State Administration for Industry and Commerce.

Western officials say one overarching challenge is the law's stated aim: "ensuring the healthy development of the socialist market economy." Says Ms. Wang, "Antitrust law is rooted in the market economy. There is a big difference in China where the biggest competitor for [private business] comes from the government itself."