Practice Midterm 3 - New Cases

How to Use This Practice Exam

The real exam may present cases you have not seen and ask you to analyze them with the same tools used in class. This practice exam does exactly that: four short new cases, each a close cousin of one Module 3 case. If you can solve these, you can solve whatever the professor puts in front of you.

Designed for about 75 minutes. Total: 120 points across twelve weighted questions, plus an unweighted synthesis question.
Read each case vignette, then answer. Hidden model answers are in callouts - in Obsidian, click the bar to reveal. Attempt your own answer first.
The mapping to Module 3: Case 1 mirrors EpiPen; Case 2 mirrors the Elevator Saga; Case 3 mirrors Liconsa; Case 4 mirrors Thai rice subsidies.

Case 1 - The Price of Insulin

Insulin was discovered in 1921; its discoverers sold the patent to their university for one dollar so that it would be affordable to all. A century later, three firms supply most of the world's insulin, and between 2002 and 2013 the U.S. list price of widely used analog insulins roughly tripled. The original molecule is long off-patent, but manufacturers obtain a steady stream of new patents on incremental changes - reformulations and new injector pens - a practice critics call "evergreening." Regulatory approval of competing "biosimilar" insulins has been slow and costly. People with diabetes need insulin daily to survive; some uninsured patients ration their doses, sometimes fatally. Manufacturers heavily promote patient-assistance coupons.

Q1 (10 pts). Why has insulin remained expensive a century after its discovery, even though the original molecule has no patent protection?

Tests: applying the barriers-to-entry framework to a new case.

[!success]- Model answer Market power does not require a single patent on the molecule - it requires a thicket of barriers to entry plus inelastic demand.

Evergreening: manufacturers obtain new patents on pens, formulations, and delivery devices, so a would-be copier still risks infringement even though the basic molecule is free.

Regulatory barriers: insulin is a biologic; approving a competing biosimilar is slow and expensive, which deters entry.

Switching costs and brand: patients stabilized on a specific insulin and pen, and the physicians who prescribe them, are reluctant to switch.

Inelastic demand: insulin is life-sustaining, used daily, with no substitute, so buyers cannot respond to price.

With entry blocked and demand inelastic, incumbents can keep price far above the cost of a century-old drug - the same logic as the EpiPen.

Q2 (10 pts). The insulin market has three manufacturers, not one. Why can a three-firm oligopoly still produce prices close to the monopoly outcome?

Tests: extending the monopoly model to oligopoly.

[!success]- Model answer A few firms selling a near-identical necessity behave very differently from a competitive market:

No incentive to start a price war. If one firm cut its price, the others would match, and all three would simply earn less on an inelastic product. So each firm refrains from undercutting - a tacit, self-enforcing restraint.

Price leadership / shadow pricing: when one firm raises its list price, the others follow rather than compete the increase away. Observers noted insulin prices of rival firms tracking each other closely.

Barriers to entry (evergreening, biosimilar hurdles) mean no outsider disciplines them.

Switching costs mean even a firm that undercut would not quickly win customers.

Few sellers + inelastic demand + barriers to entry + a homogeneous product produces an outcome close to monopoly, without any explicit agreement.

Q3 (12 pts). Manufacturers point to coupons and patient-assistance programs as proof they are tackling affordability. Why do coupons fail to fix the underlying problem? Identify who is least helped by them.

Tests: critiquing a defense - transfers the EpiPen "savings card" analysis.

[!success]- Model answer Coupons are price discrimination (couponing), not a solution.

A coupon lowers the patient's out-of-pocket cost but the insurer still pays the high list price - so the manufacturer's revenue per unit is not cut, and the list price never falls.

Coupons segment buyers and let the firm extract the most from each group, while defusing political pressure from insured patients who no longer feel the price.

Who is least helped: the uninsured and the high-deductible patients - exactly the people who ration insulin. Coupons are often unusable for them or for public-program enrollees, so the group in real danger gets the least relief.

Coupons treat the symptom (one patient's bill) while leaving the cause (the list price and the lack of competition) untouched, and they shift cost onto premiums and taxpayers.

Case 2 - The Bayside Seawall

Bayside is a coastal village of 40 households facing worsening storm flooding. Engineers propose a seawall costing USD 1,200,000 that would protect the whole village. Once built, the wall protects every household whether or not it paid, and one household's protection does not reduce another's. Beachfront households would benefit far more than those on higher ground. The village council proposes funding the wall by voluntary contributions: if pledges reach USD 1,200,000, the wall is built.

Q4 (10 pts). Explain why the seawall is a public good, and why voluntary contributions are likely to fail to fund it even if it is genuinely worth building.

Tests: identifying a public good and the free-rider problem in a new setting.

[!success]- Model answer The seawall is a public good for the village:

Non-rival: one household being protected does not reduce the protection available to another.

Non-excludable within Bayside: once the wall exists, it protects every household, including any that did not pay.

Because of non-excludability, each household faces the free-rider temptation: "I am protected whether or not I contribute, so I will pledge little and hope others fund it." If every household reasons this way, pledges fall short of the wall's true total value, and a wall whose total benefit exceeds USD 1,200,000 goes unbuilt. Voluntary contribution systematically under-provides public goods - which is exactly why the elevator case needed a better mechanism.

Q5 (14 pts). Design a pivot mechanism for Bayside. State the decision rule, how each household pays, and how a household that turns out to be pivotal is treated. Explain why the design makes honest pledging the smart choice.

Tests: constructing a mechanism, not just describing one.

[!success]- Model answer Design:

Each of the 40 households submits a pledge equal to what the wall is worth to it (pledges may be negative if a household is harmed).

Assign each household a fair share in advance - fixed, independent of pledges - for example by flood-risk zone, with the 40 fair shares summing to USD 1,200,000.

Decision rule: build the wall if and only if the sum of pledges is at least USD 1,200,000.

Payment: every household pays its fixed fair share if the wall is built - not its pledge.

Pivotal household: if a household's pledge flipped the decision (the outcome would differ had its pledge been replaced by its fair share), it pays a penalty equal to the cost it imposed on the others.

Why honesty is smart: because a household pays a fixed fair share regardless of its pledge, lowballing cannot cut its bill - the free-rider incentive is removed. Its pledge only decides whether the wall is built, and the penalty makes it bear the consequence of being pivotal. As in a second-price auction, this makes pledging the true value a dominant strategy. (The penalty surplus must be given to a party outside the village, or it would re-create gaming incentives.)

Q6 (10 pts). A careful survey finds that the 40 households' true values for the wall sum to USD 1,500,000. Should the wall be built? What if instead they sum to USD 900,000? State the rule you are using and one caveat about the survey.

Tests: applying the Samuelson condition and judging the evidence.

[!success]- Model answer Rule - the Samuelson condition for a discrete public good: build it if and only if the sum of individual values is at least the cost.

Sum of values = USD 1,500,000, cost = USD 1,200,000. Since 1,500,000 is at least 1,200,000, build the wall - it is efficient.

Sum of values = USD 900,000, cost = USD 1,200,000. Since 900,000 is below 1,200,000, do not build - the wall costs more than it is collectively worth.

Caveat: these summed values are trustworthy only if they were elicited truthfully. If households were simply asked "what is it worth to you?" with no consequence, they would misreport - understating if they expect to be billed, overstating if they want the wall and expect others to pay. A reliable total requires an incentive-compatible mechanism (like the pivot mechanism), not a casual survey.

Case 3 - Fuel Subsidies in Sumora

The Republic of Sumora, a large fuel-importing country, holds gasoline and diesel prices far below world levels through a universal subsidy available to anyone at the pump. The subsidy now consumes about a fifth of the national budget - more than health and education combined. Reformers point out that wealthier households, who own more and larger vehicles, capture most of the subsidy. They propose abolishing the price subsidy, letting fuel prices rise to world levels, and using the savings to pay targeted cash transfers to poor households.

Q7 (10 pts). A universal fuel price subsidy is usually defended as help for the poor. Why is it, in practice, regressive - the opposite of pro-poor?

Tests: reasoning about who actually benefits from a subsidy.

[!success]- Model answer The benefit a household receives from a price subsidy is proportional to how much of the good it consumes. Fuel consumption rises steeply with income: richer households own more vehicles, larger vehicles, and travel more, while the poorest may own no vehicle at all.

So in absolute terms the rich capture most of the subsidy money - a program meant to help the poor delivers the bulk of its spending to the better-off. This is a massive leakage / inclusion error. It is the same lesson as Liconsa's targeting problem, in reverse: a universal subsidy with no targeting is an expensive and poorly aimed way to help the poor, and it is regressive because the benefit tracks consumption, and consumption tracks income.

Q8 (12 pts). Why would replacing the fuel price subsidy with targeted cash transfers be both more progressive and more efficient? In your answer, bring in the externalities associated with fuel.

Tests: combining the cash-versus-in-kind argument with externality reasoning.

[!success]- Model answer More progressive: cash transfers can be targeted to poor households, so the budget reaches the intended group instead of leaking to the rich. The same money does far more poverty reduction.

More efficient (cash dominance): a cash transfer lets recipients spend on whatever they value most, and it avoids the substitution effect a price subsidy creates. A fuel price subsidy distorts choices toward fuel; cash does not.

The externality point - this makes it doubly clear: fuel consumption generates negative externalities - air pollution, congestion, carbon emissions. The efficient price of fuel is at or above its private cost (a Pigouvian logic). A subsidy pushes the price below cost, causing over-consumption and worsening pollution and congestion. Removing the subsidy lets the price move toward the true social cost, while the cash transfer protects poor households' incomes. You fix the targeting, remove the distortion, and stop subsidizing pollution - all at once.

Q9 (10 pts). Fuel-subsidy reform is notoriously hard politically, even when the economics is clear. Why? What design features make it easier to carry out?

Tests: political-economy reasoning and practical policy design.

[!success]- Model answer Why it is hard:

The price jump at the pump is visible, immediate, and salient; everyone sees it. The benefits of reform (a healthier budget, money redirected to the poor) are diffuse and slow.

Loss aversion: people react more strongly to a clear loss than to an abstract gain.

The losers include the vocal middle class and the well-off, who lose the most in absolute terms and are organized; the gainers are diffuse.

Design features that help:

Pair the reform with visible compensating cash transfers to poor (and near-poor) households, launched at the same time, so the vulnerable are demonstrably protected.

Phase the price increase in gradually rather than all at once.

Communicate clearly where the saved money goes (transfers, health, education).

Time it when world fuel prices are low, so the pump price barely moves.

Case 4 - Europe's Butter Mountain

For decades the European Community guaranteed its farmers prices for butter, grain, and beef well above world-market levels, and the authorities bought whatever farmers could not sell privately at the guaranteed price. The result became famous: "butter mountains," "beef mountains," and "wine lakes" of surplus produce sitting in storage. Surpluses were stored at great expense or sold cheaply onto world markets. The policy consumed a large share of the Community budget. Later reforms shifted support toward "decoupled payments" - direct payments to farmers not tied to how much they produce.

Q10 (10 pts). Why did guaranteed above-market prices produce persistent surplus "mountains"?

Tests: applying price-floor mechanics to a new case.

[!success]- Model answer A guaranteed price above the market-clearing level is a binding price floor. At that high price:

Quantity supplied is large - farmers expand output to capture the attractive guaranteed price.

Quantity demanded is small - buyers purchase less at the high price.

The result is a persistent surplus: quantity supplied exceeds quantity demanded. To keep the price from collapsing, the authorities had to buy the surplus, and it accumulated in storage as the "mountains" and "lakes." Because the incentive to overproduce was built into the guaranteed price, the surplus reappeared year after year - exactly the dynamic of the Thai rice stockpile.

Q11 (10 pts). Selling the surplus cheaply onto world markets - "dumping" - is widely criticized. Why is it harmful, and to whom?

Tests: identifying an international spillover / negative externality.

[!success]- Model answer Dumping subsidized surplus onto world markets pushes the world price down.

It harms farmers in other countries, especially developing-country farmers, who must compete against artificially cheap subsidized exports. Their incomes fall and their agricultural development is undermined.

It is a negative international spillover - the cost of the EC's policy is exported to producers abroad who had no say in it - and a trade distortion that misallocates global production away from lower-cost producers.

It also wastes the Community's own taxpayer money: produce bought at a high guaranteed price is sold for a fraction of that cost.

So dumping spreads the damage of a domestic price support beyond the country's borders.

Q12 (10 pts). Why was the later shift to "decoupled payments" an improvement over guaranteed prices?

Tests: evaluating a less-distorting policy alternative.

[!success]- Model answer A decoupled payment is income support not tied to output - a farmer receives it regardless of how much it produces.

Because producing more no longer earns more subsidy, the incentive to overproduce disappears. The surplus mountains, the storage costs, and the dumping all shrink. Yet farmers' incomes are still supported.

In welfare terms, the decoupled payment separates the income-support goal from the production decision. It removes the deadweight loss of over-production (resources spent making goods worth less than they cost) while still delivering the distributional aim. It is the same logic recommended for Thai rice: replace a price support with direct, decoupled income support.

Synthesis

Q13 (open, ~12 min). Pick the new case here that you found hardest. In a short structured answer, (a) name the Module 3 case it parallels, (b) state the single core concept that unlocks it, and (c) explain how you would open your answer in the exam if this case appeared cold.

Tests: transferring a framework to an unseen case - the exact skill the syllabus targets.

[!success]- Model answer A strong response does three things crisply. Example, using Case 4:

(a) Parallel: it mirrors the Thai rice subsidies - a government setting a price above the market level and buying the surplus.

(b) Core concept: a binding price floor creates a persistent surplus that someone must buy; the over-production is a deadweight loss; less-distorting decoupled support can deliver the same income goal.

(c) How to open cold: first classify the instrument ("this is a price support / price floor"), then state the efficiency benchmark it violates, then work through winners, losers, and the deadweight loss, and finish with a less-distorting alternative. Opening by naming the instrument and the benchmark signals to the grader that you have framed the problem before diving into detail.

The general exam habit: do not try to recall "the answer" to a case. Identify which of the four market-failure / intervention templates it fits, then run that template.