ECO361: LABOR ECONOMICS FIRST MIDTERM EXAMINATION OCTOBER 12, Prof. Bill Even DIRECTIONS.

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1 Name ECO6: LABOR ECONOMICS FIRST MIDTERM EXAMINATION OCTOBER, 004 Prof. Bill Even DIRECTIONS. The exam contains a mix of short answer and essay questions. Your answers to the 7 short answer portion of the exam ( points each unless indicated otherwise) should be listed on the answer sheet attached to the end of the exam. Your answers to the essays (68 points total) should be provided in the space beneath each question

2 Consider the data below for September 004 to answer the questions that follow. Civilian noninstitutionalized population Civilian labor force Employment Unemployment Not in labor force (in 000s),94 47,48 9,480 8,00 76,458 Based on the data provided, what is: the unemployment rate (round to nearest one-tenth of a percent.). the labor force participation rate (round to nearest one-tenth of a percent.). If three million workers who were unemployed become discouraged and quit looking for work, what would the new unemployment rate be? (round to nearest one-tenth of a percent.) Consider the earnings data below to answer the questions that follow: 4. What is the CPI in 00? (round answer to nearest one-tenth). 5. Compared to 990, prices in 00 are times higher (round answer to nearest one-tenth). 6. Earning $0 an hour in 98 would have the same purchasing power as $ an hour in 00.

3 Suppose that the daily output of a sign painting service is determined by the number of workers and capital according to the table below: Capital Labor Output Assume that the firm receives $ for each sign painted. If capital is currently fixed at unit, 7. What is the marginal product of the third worker? 8. What is the marginal revenue product of the third worker? 9. If the wage rate for each worker is $0 per day and capital is fixed at units, what is the profit-maximizing level of employment? 0. Suppose that the daily rental rate of capital is $0. Among the possible choices listed in the above table, what is the profit maximizing mixture of labor and capital?. Suppose that the MP of labor and capital are 0 and 60, and that their respective prices are 5 and 40. Based on this information, the firm a. is minimizing its cost of production. b. could use more labor and less capital to lower its costs of producing the current output. c. could use less labor and more capital to lower its costs of producing the current output. d. might be able to lower its costs of producing the current output, but without knowing the price of the output, it s impossible to tell.. In a small, rural community, the aggregate labor supply curve is given by Ls = w and aggregate labor demand by Ld = 80-0w, where w is the hourly wage rate. Calculate the equilibrium level of employment and wage. The equilibrium wage rate is and the equilibrium level of employment is.. Suppose that the wage of medical doctors increases. This should cause the demand for nurses to: a. increase b. decrease c. increase only if doctors and nurses are gross substitutes for each other. d. increase only if doctors and nurses are gross complements for each other.

4 4. If the quantity of steel workers demanded falls from 0,000 to 0,000 when the equilibrium wage increases from $9.00 per hour to $0.00 per hour, then the own-wage elasticity of demand for these workers is. (Round answer to nearest tenth). 5. If the own-wage elasticity of demand for professors is -0.5, then an increase in the wage of professors from $45,000 to $55,000 will cause the quantity demanded to fall by percent (round answer to nearest tenth of a percent). To answer the next questions, suppose that a defined benefit plan provides an annuity at retirement equal to percent * years of service * final salary. Jerry started with the firm at age 5 and would have 0 years of service if he retires at 55, he would receive an annual benefit equal to 60% of his final salary. Assume that Jerry will live until age 85, that there is a zero interest rate, and his final salary will be $00,000 regardless of when he retires. 6. For the pension to be actuarially fair, it would have to increase the annual benefit by $ for postponing retirement from age 55 to age The size of the actuarially fair increment in the pension would be larger if the interest rate is (higher, lower) or if life expectancy is (higher, lower). a. higher; higher. b. higher; lower. c. lower; lower. d. lower; higher.

5 . (6 points) The Kerry campaign is proposing a minimum wage hike from $5.5 to $7.00 to ensure that no one working full-time at the minimum wage will have to raise his or her children in poverty. a. Why do some economists believe that a hike in the minimum wage is a blunt anti-poverty tool that may have a relatively small effect on poverty? The primary reason is that the majority of minimum wage workers live in families with other earners and the family is not in poverty. Also, a hike in the minimum wage could cause some workers to lose their jobs and thus increase poverty for some. b. How and why does the elasticity of labor demand alter the effect of the miminum wage hike on poverty? If labor demand is more elastic, a hike in the minimum wage will cause a greater number of workers to lose their jobs. Consequently, the more elastic labor demand is, the less effective a minimum wage hike will be in eradicating poverty.. (6 points). In the state of Ohio, the average employer pays.7 percent of a worker s wages to finance the unemployment insurance system. The tax rate applies only to the first $9,000 of a worker s wages. Consequently, if a worker earns less than $9,000 over the year, the firm will have to contribute.7% of earnings. If the worker earns $9000 or more, the firm contributes.7 of $9,000. a. Is the above payroll tax a quasi-fixed cost? Why or why not? If a worker earns more than $9000 per year, the payroll tax is fixed at.7 percent of $9,000. Consequently, for workers earning above $9000 annually the payroll tax is a quasi-fixed cost since it will not increase with additional hours per worker, but will increase with the number of workers. For workers earning less than $9000 per year, the payroll tax is a variable cost since it will increase as hours per worker increases. b. If the state of Ohio increases the taxable earnings level from $9,000 to $8,000, how would this affect the likelihood that a worker could find part-time (instead of full-time) work? Provide a brief justification for your answer. If the taxable earnings level is increased from $9,000 to $8,000, the size of the quasi-fixed cost is doubled for anyone earning over $8,000 per year. For such workers, firms have an incentive to use fewer workers and increase hours per worker to save on payroll taxes. For workers who were earning less than $9,000 annually, there is no effect. For workers earning between $9,000 and $8,000, a quasi-fixed cost has been converted into a variable cost and, assuming output is held constant, the firm has an incentive to decrease hours per worker and increase the number of workers.

6 . ( points) Suppose that workers can go to firms without training and earn $0,000 per year for the remainder of their work life (suppose that is 0 years). Assume a zero interest rate. Further, suppose that Compucon (a fictional employer) provides firm specific training at a cost of $5,000 in the first year and the worker produces nothing during that first year. The training will increase the worker's productivity to $,000 in years -0. a. If Compucon pays workers $0,000 per year for 0 years and can force workers to stay for 0 years, should it increase or decrease the number of workers to maximize profits? why? The worker s PVP=,000*9=48,000 and PVC=5, ,000*0=$45,000. Consequently, since the present value of the worker s production over the career (PVP) exceed the present value of the costs of hiring the worker (PVC), the firm should hire more workers to maximize profits. b. If Compucon cannot force workers to stay for the 0 years, how should it structure pay to increase the chance that the worker will stay? Why will this achieve the desired objective? To increase the chance that workers will stay, Compucon should offer deferred pay. For example, they could increase the worker s wage above $0,000 in the post-training period so that the worker is less likely to switch to their next best alternative after the training is complete. To allow the firm to pay above $0,000 after the training period and still break even the firm needs to reduce pay below $0,000 prior to training. c. Why might employees be reluctant to accept the kind of pay system described in b? If a worker accepts such a contract, there is a risk that they will never receive the deferred pay. The deferred pay could be lost if the firm goes bankrupt; the firm chooses to ignore the contract; or the worker is forced to leave the firm for some personal reason. The worker might also have difficulty borrowing money early in her career to offset the low wages in the training period d. If the training provided by Compucon was general instead of firm specific, how much could Compucon pay the worker in the first year if it is to break even on the worker and can't force the worker to stay? If the training is general, Compucon will have to pay $,000 per year after the training is complete or the worker will leave to the next best alternative. This comes to a total of $k*9=$48,000 and equals the entire value of what the worker produces in the post-training period. Consequently, to break even on the worker, the firm would have to charge the worker $5,000 for the training in the first period and pay them a wage of zero since the worker does not produce anything in the first period.

7 4. ( points) The Kerry campaign is proposing that it will stimulate job creation with a job tax credit. Quoting from the Kerry website: New Jobs Tax Credit. As president, John Kerry would jumpstart manufacturing job creation with a New Jobs Tax Credit that would pay the employer share of the payroll taxes for any net new jobs created by manufacturers, other businesses affected by outsourcing, and small businesses in 005 and 006. For example, a medium-sized manufacturing company employs,000 workers. If this company hires an additional 00 employees at $40,000 bringing the total to,00 workers they would get a tax cut of $,060 per worker $06,000 in total. a. Based on the above, use a labor supply/demand model to illustrate how the tax credit would create new jobs and how it would affect the equilibrium wages of workers. Notice that it is the employer that gets the tax credit. Draw and refer to the labor supply/demand curves in your explanation. w w0 LS LD' LD The tax credit will increase labor demand illustrated as a shift from LD to LD in the diagram. (Note that the tax credit is given to the employer so labor demand, not labor supply, is affected.) This causes the wage to rise from w0 to w and employment to rise from L0 to L. L0 L b. How does the elasticity of labor supply alter the impact of the tax credit on wages and employment? w' w w0 LS' LS LD' LD The labor supply curve LS is more inelastic than LS. With the more inelastic labor supply curve, the wage would increase more (to w ) and employment would increase less (to L ). That is, the number of jobs created would be smaller and the wage increase larger if labor supply is inelastic. L0 L' L c. How would the size of the wage and employment effects of this tax credit at a particular firm depend upon (a) the labor intensity of the production process; and (b) the ability to substitute labor for capital and vice versa. Explain. Both (a) and (b) would make labor demand more elastic according to the Hicks-Marshall laws of derived demand. w w0 LS' LS LD' LD L0 L

8 5. ( points) As discussed in class, the Social Security system calculates a person s normal retirement benefit for a retirement at age 65 (though this age is rising over time). For each year that a person postpones retirement beyond age 65, the size of the monthly Social Security check is increased by a certain percentage. The size of the delayed retirement credit has increased over time. For example, for workers born in 94 or earlier, the benefit was increased by.0% for each year a worker postponed retirement beyond the normal retirement age. For workers born after 94, the credit is 8.0% for each year retirement is postponed. a. To simplify matters, assume that the normal retirement age is 65 for everyone. Draw a budget constraint illustrating the effect of an increase in the credit for postponing retirement. Be sure to label what is measured on the axes of your graph. PV of lifetime income D C B Increasing the reward for delayed retirement beyond age 65 will twist the budget constraint from one like ABC to one like ABD. A Retirement age 60 b. Use budget constraints and indifference curves to describe how the increase in the credit for postponing retirement should affect retirement age. If the effect varies according to when the worker would have retired with the.0% credit, explain how and why. (If the answer depends on the relative size of income and substitution effects, explain the direction of each.) z y B x The three indifference curves at the right (x, y, and z) illustrate the possible effects of the increased retirement credit. For a person who previously retired before age 65 (x), there is no wealth effect. The substitution effect could cause the person to delay retirement beyond 65, but this would require a flatter indifference curve Retirement age 60 The person who previously retired at age 65 (y) has no wealth effect but the substitution effect would cause this person to retire later. The person who previously retired beyond age 65 (z) experiences offsetting wealth and substitution effects. The wealth effect would cause him to retire sooner, but the substitution effect would cause him to retire later. The net effect depends on the relative magnitudes of the two.

9 6. (0 points) Consider the budget constraint for Joe given below to answer the questions that follow. Total income per week 0 D E B 500 A 00 C hours of leisure per week a. What is Joe s hourly wage and non-labor income? Wage = $0 per hour; Non-labor income=$00 per week. b. On the budget graph above, draw a budget line representing the following unemployment insurance program assuming that Joe previously worked 40 hours per week and becomes unemployed. Provide numeric detail for earnings and hours associated with key points on the new budget line. Upon being laid off, the worker will receive an unemployment insurance check that replaces 50% of her prior labor earnings. If he accepts a new job and earns up to / of prior earnings, the unemployment insurance check is not reduced. If he accepts a new job and earns more than / of prior earnings, the unemployment insurance check is eliminated. The new budget line is ABCD. Joe can earn up to $00 without a reduction in unemployment insurance. This would require that he work 0 hours (9 hours of leisure) at a wage of $0 per hour. c. Refer to your budget constraint above to describe the range of hours worked that would be inconsistent with utility maximization. Why would working in this range be irrational? Joe would not work between 0 and 40 hours per week (along the portion BE on the budget line) since this would result in less total income and less leisure than the point B.

10 Total. income per week 0 Z Y X hours of leisure per week d. Suppose that the program is adjusted so that the unemployment insurance benefit is reduced by $.50 for every $ earned. Draw Joe s budget constraint for this system on the diagram above. Provide numeric detail to illustrate key points on the budget line. The new budget line is given by XYZ. e. Would the change in the UI program described in (d) cause a person to work more or less hours? Why? (If the answer depends on how much they worked under the old program, explain how.) If the person was working more than 0 but less than 0 hours per week, the effect is ambiguous. The substitution effect will cause them to work less hours but the income effect will cause them to work more hours. If the person was working more than 40 hours or 0 hours initially, there will be no effect on hours worked.

11 Name Answer Sheet. 5.4% 65.9%.5% capital and labor, or capital and labor B $0.50; 75 c.8 0.0%,069 B