UNIVERSITY OF NORTH CAROLINA ECONOMICS 101h: HONORS INTRODUCTORY ECONOMICS PRACTICE EXAMINATION # 1

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1 UNIVERSITY OF NORTH CAROLINA ECONOMICS 101h: HONORS INTRODUCTORY ECONOMICS PRACTICE EXAMINATION # 1 Prof. B. Turchi 9/8/006 GENERAL INSTRUCTIONS: There are eight (8) questions on this examination; please answer them all. Sign the honor code pledge on your blue book. Please write legibly and remember, quality and precision beat quantity every time. Read the following editorial from The Daily Tar Heel and then answer the following 8 questions. Makin a Living The living wage law in Santa Cruz, Calif. marks a great stride toward social equality. It s an idea worth serious local consideration. It s a poor indication of economic equality when the city you work in cannot be the city you live in. That s why the city of Santa Cruz, Calif. was right when it recently established an $11 living wage in place of the federal minimum wage for town employees to help them make a decent living in today s economy. It is an act other cities with a high cost of living should follow - including Chapel Hill. By implementing this new living wage, the minimum wage in Santa Cruz will rise from $5.75 per hour to $11 dollars per hour with health benefits and $1 dollars per hour without benefits for permanent city workers, such as social workers, as well as commercial companies and nonprofit organizations that enter into contracts with the city. Santa Cruz is not the first city to enact a living wage higher than the federal minimum wage; Chicago, for example, has instituted a $7.60 hourly wage while San Jose, Calif. has raised their minimum hourly wage to $9.50. But Santa Cruz is the first city to increase the minimum wage so substantially. There are several practical implications of this wage increase. In recent years, Santa Cruz, like many other cities, has experienced a drastic rise in the cost of living because of the current economic boom and financial triumphs of high-tech companies found in its region. The housing market in Santa Cruz has currently undergone a 30 percent rise in housing and rental costs, meaning that the average home sells for close to $350,000. The new wages will take some of the financial burden off city workers, who should receive a salary that will enable them to at least reside in the city where they work. The measure also might ensure that the city can compete for better workers now that it offers a competitive wage. The living wage, though very practical, also possesses symbolic significance. As Vice Mayor Fitzmaurice puts it, We re upping the ante on paying people a fair wage, hoping that cities all over the state will see what we re doing and follow suit. Other cities should be obligated to provide a wage that will sufficiently support its workers. Chapel Hill is one such city, as it too is facing a crunch in affordable housing. Santa Cruz has taken a step in the right direction; now other municipal governments need to recognize the need for better wages for the workers who keep our cities running. The Daily Tar Heel, 10/19/00 1. (11 points) Suppose the distribution of workers in Santa Cruz looks like the following chart, 0.1 Distribution of Wage Earners by Wage Rate in Santa Cruz Proportion of Workforce % 55% Hourly Wage Rate mtm1f06_honors.lwp Midterm # 1 Honors Econ 101 Page 1 of 6

2 where the distribution shows the proportion of the local labor force that would earn less than a given hourly wage rate in the absence of a $5.75 hourly minimum and in the absence of an $11 hourly minimum. a) What would be the maximum unemployment rate in Santa Cruz before the city-minimum wage rises from $5.75 per hour (assuming that the labor market would reach equilibrium in the absence of any minimum wage law)? The maximum unemployment rate would be 5% because 5% of the labor force would earn less than $5.75 per hour in a totally unregulated market. However, not all of the market is regulated -- only city employees and private firms and organizations doing business with the city -- so the actual unemployment rate could be substantially less. b) What would be the maximum rate if the city-minimum were raised to $11 per hour. The maximum unemployment rate would be as high as 80% (5% + 55%) because 80% of the labor force would earn less than $11 per hour in a totally unregulated market. However, not all of the market is regulated -- only city employees and private firms and organizations doing business with the city -- so the actual unemployment rate could be substantially less.. (11 points) There are essentially two labor markets in Santa Cruz: (1) the city and firms doing business with the city; () everybody else. Explain what would happen to supply and demand in the two markets if the city raised the minimum wage to $11 from $5.75, as described in the editorial (Assume the original minimum wage was effective in both markets). Use graphs to support your answer. In both markets there would have been excess supply of labor at $5.75 per hour. After the city raises the city-related minimum wage, the excess supply of labor would rise in the city-related market. Employment in that market would fall, even if the city did not cut any of its jobs, because the city-contractors would likely reduce their quantity of labor demanded. Neither curve would shift in this market. In the unrelated market, employment would neither fall nor rise (unless the rise in incomes from the higher paid city workers caused a rightward shift in demand or the fall in incomes of those who lost jobs in the city-sector caused demand to shift to the left. The net effect is ambiguous). However, the supply of labor would rise (rightward shift) as those who lost employment in the city-related market would seek employment in the unrelated market. There would most likely be a net decline in employment overall. $11.00 Excess Supply After S WageRate $11.00 S($5.75) S($11.00) $5.75 Excess Supply Before $5.75 Wage Rate Decline in Employment D Excess Supply Rises D Employment in City-Related Work City-Related Labor Market Employment in Unrelated Work Unrelated Labor Market 3. (11 points) Two types of firms bid for city contracts. Emblematic of one type is landscaping companies that tend the city gardens. They tend to use immigrant labor from Mexico. Emblematic of the other type is computer consulting firms that manage the city s data processing activities. Explain how each of these firms would be affected by the city s new minimum wage. mtm1f06_honors.lwp Midterm # 1 Honors Econ 101 Page of 6

3 The landscaping firms would have to pay their workers far more than they do now. In order to break even, they would have to raise their contract prices to the city. Prices for city services performed by low-skilled workers would rise, either because the city had to pay them more or because the firms that the city hires had to pay them more. In any case the cost of these services would rise. The computer consulting firms would probably not be affected. Most of their workers earn more than $11 per hour (that s only about $,000 per year), so they would not raise prices to the city because their costs likely would not have risen. 4. (11 points) City managers and firms doing business with the city will face higher labor costs after the new minimum wage comes into effect. How might they attempt to respond to these higher labor costs? What would happen to the costs of producing city services? Use graphs to illustrate your answer. They would attempt to substitute away from these higher labor costs by using more capital equipment or other inputs. How successful they could be would be determined by the degree of substitutability between inputs. In the graph below, costs rise substantially because substitutability between capital and labor is not perfect. The manager shifts from A to B, raising the capital-labor ratio in the process. Nevertheless, costs of producing 00 units of output still rise. Cost Increase K B A Q=00 units L 5. (11 points) Assume that the city fathers in Santa Cruz decide to maintain the same level of services after they raise the city-minimum wage. What would they have to do in order to achieve this? Describe who would be affected by their actions? Basically, the city would have to raise taxes in order to maintain the same level of services. All groups would have to pay more taxes. Low income people who saw their wage income rise because of the new minimum wage would have to pay some of that extra income in the form of higher taxes. Those who lost their jobs as a consequence would also have to pay higher taxes (most city services are financed through property taxes). Middle and upper income people would pay more taxes, which would be used to pay the higher salaries of city workers. So they would be (perhaps unknowingly) participating in a redistributive tax scheme. 6. (11 points) Show what will happen to housing prices and quantity of housing provided as a consequence of the new minimum wage. (Remember that city services are generally financed by property taxes) The increase income of city-workers might lead to a rise in demand for housing, if that increase more than offsets the fall in income of those who lose their jobs. The increased cost of city services will probably lead to a shift in supply because of increased property taxes. In general, we expect the new minimum wage to raise housing prices in Santa Cruz. The quantity of housing actually supplied may rise, fall or stay the same. (see graph below) mtm1f06_honors.lwp Midterm # 1 Honors Econ 101 Page 3 of 6

4 Safter Price of housing Sbefore $350k Dafter Dbefore Quantity of housing 7. (11 points) Suppose that the Santa Cruz Landscapers Association (the industry trade group) is trying to assess the impact of trying to pass on higher wage costs to the private sector market in Santa Cruz. They have Santa Cruz market data from January, 1999 and from July, 1999 as shown in the table below. (a) What is the elasticity of demand that the landscapers face? What will happen to their revenue if they raise prices? (b) How sure are you that the elasticity you calculated is the true elasticity? Why/Why Not? January, 1999 July, 1999 Units (Quantity) of Landscaping 1,14 1,655 Price per unit $1.00 $10.00 Qa Q b Qa Q b Pa P b Pa P b 1,655 1,14 1,655 1, , (a) If they raise their prices they will lose total revenue, because the price elasticity of demand is greater than one. Consequently, they will be reluctant to raise prices. (b) I am not very sure that I ve got the true price elasticity. The reason is, that I m not sure that the other factors that determine the position of the demand curve have remained constant over the intervening months. In particular, the change of seasons could have led to a shift in the demand curve, and this could then distort the result. mtm1f06_honors.lwp Midterm # 1 Honors Econ 101 Page 4 of 6

5 P 1 Actual Demand Curve 10 Actual Demand Curve Estimated Demand Curve 1,655 1,14 Q 8. Suppose that there are two households with the same income that face the same prices for food and clothing. The households differ only in that household A contains three teenage girls and household B contains 3 teenage boys. After a month has passed, the Consumer Price Index data shows that clothing prices have risen and food prices have fallen (because of a large harvest) such that household B s purchasing power is unchanged. (a) (15 points) Draw a graph that shows the situation just described and explain how each household s situation has changed with respect to purchasing power. Clothing A B Food Obviously household B s purchasing power is unchanged, while household A s purchasing power has declined. (b) (15 points) Has household A s welfare changed more, less, or the same as its purchasing power? Why? (draw graph illustrating your answer) Would the Consumer Price Index overstate, understate, or correctly state the household s change in welfare? Why? Household A s welfare would have declined, but not by as much as its purchasing power. Because we assume that household A s preferences exhibit some willingness to substitute food for clothing, we would not have to raise household A s income (dotted budget line to Point A ) as much to regain initial welfare level as we would to regain the household s original purchasing power (solid line). Since the CPI doesn t recognize this willingness to substitute, it would suggest that household A s welfare has changed more than it actually has. mtm1f06_honors.lwp Midterm # 1 Honors Econ 101 Page 5 of 6

6 Clothing A B A' Food mtm1f06_honors.lwp Midterm # 1 Honors Econ 101 Page 6 of 6