Economics 27 Professor Patricia M. Anderson s1

Economics 27 Professor Patricia M. Anderson

Practice Problem Set 2

(ANSWERS)

Multiple Choice Questions

1. Answer is D. Why? The reduction in fixed costs represents a shift out in the budget line. For a working individual, this is a pure income effect and implies buying more leisure, and hence working less as in A (the exact opposite of B). For an individual balancing on the “spike” of nonparticipation, the shift out may be sufficient to reach a tangency with a higher indifference curve by participating, as in C.

2. Answer is D. Why? We usually think of compensating differentials predicting higher wages for worse conditions, holding constant worker characteristics, as in B. Not holding characteristics constant, as in A, implies that workers in worse conditions may not earn more because they are less-skilled workers. It may seem that holding wages constant, as in C, makes it impossible to think about compensating differentials. Thinking more carefully, though, the theory of compensating differentials implies that rather than getting a return to skill in the form of wages, the return may be in the form of better working conditions.

3. Answer is B. Why? Working 3000 hours means choosing 1000 hours of leisure and being on the top half of the budget line. At that point, the rotation out of the budget line due to the program leads to a flatter line, representing a cheaper price of leisure. Thus, the substitution effect implies buying more leisure and working less. At the same time, the movement out represents more income, so the income effect implies buying more normal goods, like leisure, and working less.

4. Answer is C. Why? Working 1000 hours means choosing 3000 hours of leisure and being on the bottom half of the budget line. At that point, the rotation out of the budget line due to the program leads to a steeper line, representing a higher price of leisure. Thus, the substitution effect implies buying less leisure and working more. At the same time, the movement out represents more income, so the income effect implies buying more normal goods, like leisure, and working less. If the substitution effect is greater than the income effect, work will increase.

Short Answer Questions

1. See diagram below. Persons with preferences like A match up to the cool, quiet $6 office jobs, while persons with preferences like B match up to the hotter, noisier $8 factory jobs. Both firms are on their zero profit isoprofit curves.

2. As long as we assume that markets are competitive, and that workers are both well informed and mobile, then both A and B are utility maximizing. If women have preferences like A, and men have preferences like B, then the men choose hotter, noisier jobs that pay $8 and women choose nicer jobs that pay $6. Those in $6 jobs would have lower utility (A’) in the same $8 jobs.

3. The way I’ve drawn it, the firms currently offering $6 jobs (office buildings) will be unable to offer $8 jobs and stay on the same isoprofit curve. To offer an $8 wage would force it onto a higher isoprofit curve, where it would be losing money. Thus only jobs at the factories will be able to offer $8 jobs. It’s possible to have a diagram in which the office buildings move along their isoprofit curve by saving money on amenities (perhaps they save on utilities by turning off the AC after hours when the janitors work). In either case, the women will be on lower indifference curves by taking the $8 jobs that are now hotter and/or noisier.

4. In the diagram on the left below, the lighter budget line A is appropriate for this parent.

5. With the fixed costs, the budget line shifts down to the heavier line B. Note that the “spike” is part of the budget line. Thus an individual with a high marginal utility of leisure that would work 20 hours (40 hours of leisure) may drop out of the market, as shown. An individual with a lower marginal utility of leisure is more likely to not only continue to work, but to work more hours since the shift in of the budget line represents a pure income effect.

6. In the diagram on the right above, the heavy line represents the budget line with day-care costs and the new subsidy program.

7. Without the program, both parent A and parent B would choose not to work (they are captured by the “spike”), but A has a relatively lower marginal utility of leisure. A is the same as the person on the left side, and in the presence of the program will go back to working 20 hours. B, with a high marginal utility of leisure, remains out of the labor market.