Part A: Multiple Choice Questions (26 points, 40 % of test grade)

Question	1	2	3	4	5	6	7	8	9	10	11	12	13
Answer	c	c	c	c	a	b	a	c	c	c	d	d	B

Part B: “Problems” (39 points= 60% of test grade) Please answer all questions.

1. (8 points= 4+1+3) Suppose an individual has $10 of non-labor income, and has 17 hours (per day) to be used for work or leisure. Given a wage of $8 per hour she chooses to work 4 hours.

a) Depict this situation graphically, including the indifference curve. Label and quantify the slope and intercept of the budget line and the choices for C and L.

Here the intercept is $146, the slope is –8, C=$42, and L=13 hours.

b) The person becomes eligible for a 25% tax credit. In turn, she chooses to work 6 hours. What does this imply for the relative magnitude of the income and substitution effects?

The substitution effect must have been greater than the income effect because she chose to work more hours.

c) In the graph above (or a new one), indicate the new situation, and carefully identify the income and substitution effects.

2. (6 points= 3+3) Our labor supply model makes predictions regarding the EITC’s impact on the labor supply of mothers.

a) What are these predictions?

The participation rate should be greater as a result of the EITC.

For many women (those in the plateau and phase-out ranges for this credit), there are work disincentives, so we’d expect the average number of hours (and/or weeks) to decline.

b) Bruce Meyer’s article analyzed the data. Was his evidence in line with the predictions? Explain!

Participation rates for mothers increased (a lot, for those with little education). But weeks and hours did not fall (even increased for some).

3. (6 points) There has been a concern about the retirement of the large baby boomer generation and its impact on government budgets. To reduce the number of retirees, one policymaker has proposed a tax credit of 15% on labor earnings for all workers over the age of 60. Another policymaker called that proposal “risky” in the sense that it might not have the desired impact. Is that true? Use our model of retirement choice to explain.

As most recognized, this works like a wage increase. The “risk” comes from the fact that substitution and income effects work in opposite directions, where the former encourages delaying retirement, while the latter induces earlier retirement.

It was correctly noted by some that this tax credit would have to be paid for, too, so it’s also risky in the sense that the government is saving on Social Security when someone delays retirement, but is also losing revenue through the tax credit.

4. (11 points= 4+2+1+1+3) The table below shows the levels of the labor input (worker hours) and the firm’s output (say, pounds of potatoes) that would be obtained at those levels of E. One unit of output (one pound of potatoes) sells for $0.50.

E	TP	MP_E	VMP_E
0	0
1	20	20	$10
2	38	18	$9
3	53	15	$7.50
4	65	12	$6
5	75	10	$5
6	80	5	$2.50
7	80	0	$0

a) Complete the table.

b) Sketch this firm’s demand for labor

c) If the wage in the potato-farming industry is $5, how many hours of work will the firm demand?

5 hours: That’s when w=VMP_E

d) If the wage in the potato-farming industry increases to $9, what will happen to the firm’s demand for labor?

It would fall to 2 hours.

e) Over this range (i.e. as the wage changes from $5 to $9, calculate the elasticity of this firm’s demand for labor.

It’s the percent change in the demand for labor divided by the percent change in the wage.

The percent change in the demand for labor is (2-5)/5.

The percent change in the wage is (9-5)/5.

So the elasticity is –0.75.

5. (8 points= 5+3) Suppose that the supply curve of labor in a competitive industry is given by E_S=20+2w. The demand curve for labor is given by E_D=50-4w.

a) What is the equilibrium wage and employment? What is the unemployment rate?

In equilibrium, E_S=E_D, or 20+2w=50-4w. Solve! That gives w=5. Then E=E_S=E_D=30. There is no unemployment here, so the unemployment rate is 0.

b) Suppose now the government sets a minimum wage of $8. How many workers would lose their jobs? What is the unemployment rate in this labor market now?

Then E_D=50-4(8)=18. So 12 of the 30 above lost their job.

E_S=20+2(8)=36.

That means 36-18 workers are unemployed, and the unemployment rate is 18/36=0.5, or 50%.