i think i would answer the question by telling me friend that someone around the area where he was sitting told me to tell him (since he is my friend) that they will report him to the professor unless he turns himself in. This would probably be the model answer.
I dont think turning your friend in is going to win you a lot of points. Morality is subjective in this type of a case, the friend is not hurting you and what if you saw something but wasnt sure it was cheating? if it was blatant cheating, is it within your moral compass to report that? I know its probably the school's policy but this question can go either way.
I think the best answer would depend on the interviewer. If an older adcom with give you an indication of going by the book, then you might as well tell him/her what they want to hear. If the adcom is younger and seems more liberal then I think you can try the above approach.
A quick "yes I would tell on him" would mean that you either have no tact or way of speaking with people (i.e. your friend about the matter) or you did not take the time to really think about the answer.
ps I hope I am not asked this question because in all honesty, 99% of people would not squeal on their friend, but this hypo might make or break your interview.