University of North Carolina, Economics 190, Fall.

Midterm Exam 1, September 27, 2002.

Part A: Multiple Choice Questions (28 points, 47 % of test grade)

1. The statement “a large benefit reduction rate reduces work incentives” is

a) a contrapositive statement.

b) a negative statement.

c) a normative statement.

d) a positive statement.

2. If 210 million people are in the working-age population, and the labor force participation rate is 67%, then

a) 140.7 million people are outside the labor force.

b) 140.7 million people are employed or are looking for work.

c) 140.7 million people are employed.

d) 3.2 million people are looking for work.

3. Abby and Jed are two people who are currently working the same (positive) number of hours. At the current choice, Abby has a steeper indifference curve than Jed. We can conclude that

a) both are earning the same hourly wage.

b) Abby is earning a higher hourly wage than Jed.

c) Jed is earning a higher hourly wage than Abby.

d) Jed has a higher reservation wage than Abby.

4. If Jack’s wage increases and he decides he would like to work fewer hours, then we know

a) his income effect is greater than his substitution effect.

b) his substitution effect is greater than his income effect.

c) his income and substitution effects are equal.

d) his income and substitution effects work in the same direction.

5. A wage increase from below Joe’s reservation wage to above Joe’s reservation wage will have

a) income and substitution effects that work in the same direction.

b) income and substitution effects that work in opposite directions.

c) only an income effect.

d) only a substitution effect.

6. Women’s labor supply responds more positively to wage changes because

a) working men behave fundamentally differently from working women.

b) women’s participation rates respond more strongly to wage changes.

c) men and women work in different jobs.

d) women have lower reservation wages.

7. The participation rate for men

a) is relatively constant over their working life.

b) increases throughout their working life.

c) decreases throughout their working life.

d) initially increases and then decreases over their working life.

8. Empirically, the labor force participation rate

a) and the unemployment rate are negatively correlated.

b) and the unemployment rate are positively correlated.

c) is independent of the unemployment rate.

d) is simply 1 minus the unemployment rate.

9. In our retirement model, a wage increase would make retirement

a) no more and no less attractive than before.

b) longer because income and substitution effects work in the same direction.

c) shorter because income and substitution effects work in the same direction.

d) longer or shorter because income and substitution effects work in opposite directions.

10. Suppose the wage rate is $12. In a small firm in this industry, the 20^th worker-hour hired added 4 units to total output. The 21^st worker hour added 3 units to total output. The firm’s output sells at a unit price of $3. We can conclude that

a) the firm would hire fewer than 20 worker-hours.

b) the firm would hire exactly 20 worker-hours.

c) the firm would hire exactly 21 worker-hours.

d) the firm would hire more than 21 worker-hours.

11. An industry’s demand for labor is

a) exactly as elastic as a firm’s demand for labor.

b) exactly as elastic as the industry’s supply of labor.

c) more elastic than a firm’s demand for labor.

d) less elastic than a firm’s demand for labor.

12. Other things equal, if demand for the industry’s output becomes more elastic, then

a) the elasticity of labor demand will become positive.

b) the elasticity of labor demand will turn to zero.

c) The demand for labor becomes more elastic.

d) The demand for labor becomes less elastic.

13. If the price of pizza ovens increases and, soon after, the demand for pizza bakers decreases, then we would conclude that

a) ovens and pizza bakers are substitutes in production.

b) ovens and pizza bakers are complements in production.

c) ovens and pizza bakers are inferior inputs.

d) pizza bakers are male.

14. Our simple supply and demand model predicts that an increase in the minimum wage leads to

a) fewer people looking for work.

b) a decrease in the quantity of labor demanded.

c) people leaving the labor force.

d) an increase in employment.

Part B: “Problems” (32 points= 53% of test grade)

1.) [11points] Assume for simplicity that everybody pays the same tax rate (the same fraction of their income is paid in taxes). Now suppose this tax rate is cut for all, from, say, t=0.4 to t=0.3.

a) What would happen to an individual’s choice of hours of work? Can we make a clear prediction?

The tax cut works like a wage increase. For those already working there is no clear prediction. The income effect leads to more leisure, and the substitution effect leads to more hours of work. Some people will enter the labor market; for those hours of work are going up.

b) Illustrate your answer to (a) graphically.

c) What would happen to the participation rate? Can we make a clear prediction?

The participation rate would increase. Some will enter the labor market, and none will leave.

2.) [10 points] Recall our model of retirement choice.

a) Depict the model graphically, and describe what the graph shows.

As in the static labor supply model, there is a trade-off between leisure (years of retirement) and consumption (remaining lifetime consumption), here because pensions are usually smaller than salaries and because pension benefits tend to be higher if you retire later. The individual picks the ‘best’ attainable combination of C and YoR.

b) What will happen to the optimal choice when pension benefits are increased for all? Can we make a clear prediction?

Yes, we can. Income and substitution effects work in the same (!) direction. People would retire earlier, that is, people would choose more “years of retirement”.

c) Show what change would occur in your graph.

[The budget line would rotate (‘counter-clockwise’) around the “V80” point- the increase in pension benefits wouldn’t change consumption available to persons who never retire.]

3.) [11 points] Consider a firm where output is produced with only two inputs- labor and capital- with input prices w and r, respectively. Initially the firm faces market prices w=9 and r=6. These input prices then increase to w=10 and r=8.

a) In which direction will the scale effect change the firm’s employment and capital stock? Explain.

The marginal cost of producing any given level of output has increased. The firm would cut production and hire less of both capital (K) and labor (E).

b) In which direction will the substitution effect change the firm’s employment and capital stock? Explain.

The ratio w/r was 1.5, and fell (!) to 1.25. The iso-cost line got flatter. Or, to say the same thing differently, the [percentage] increase in the price of capital was greater than the [percentage] increase in the price of labor. So labor (!) became cheaper, in relative terms. As a result, the firm would use less capital, and more labor in its place.

c) Can we say conclusively whether the firm will use more or less labor? Can we say conclusively whether the firm will use more or less capital?

We don’t know whether the firm will use more or less labor overall- that depends on the relative size of the scale and substitution effects.

We can quite confidently say that the firm will use less capital, because for capital both effects point in the same direction.