4. Answer c. The index of nominal wages for 1996 is the nominal wage in 1996 expressed as a percentage of the nominal wage in the base year.

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1 Answers To Chapter 2 Review Questions 1. Answer a. To be classified as in the labor force, an individual must be employed, actively seeking work, or waiting to be recalled from a layoff. However, those actively seeking work or waiting to be recalled from a layoff are called unemployed. Hence, the labor force can be defined as those employed plus those unemployed. 2. Answer a. The labor force participation rate is defined as those in the labor force divided by the population. The labor force is those employed plus those unemployed. 3. Answer d. The unemployment rate is defined as the number unemployed divided by the labor force, but recall that the labor force is the number employed plus the number unemployed. 4. Answer c. The index of nominal wages for 1996 is the nominal wage in 1996 expressed as a percentage of the nominal wage in the base year. $11.18 $ = Answer b. The index of real wages is the index of nominal wages divided by the price index (with the result multiplied by 100) = Answer b. Since the index of real wages declined from 100 to 92, the real wage declined by 8% over the period. 7. Answer d. Although the words income, earnings, and wage are often used interchangeably in the English language, in this chapter they each refer to a different measure. The wage is defined as the payment per unit of time, while earnings equal the wage multiplied by the units of time worked. Adding employee benefits to earnings yields a worker s total compensation. Total compensation plus any unearned income yields total income. Therefore, even if the real wage falls, total income may not fall if the time spent working increases, benefits increase, or unearned income increases.

2 244 Ehrenberg/Smith Modern Labor Economics: Theory and Public Policy, Tenth Edition 8. Answer d. The demand curve represents the relationship between the wage and quantity of labor firms wish to hire provided all the other things that can influence the quantity of labor demanded are held constant. Responses a and b are examples of non-wage determinants of the total demand for labor in the market. Note that the demand curve is constructed independently of the supply curve. 9. Answer d. The demand curve slopes downward in the long run because of the substitution and scale effects associated with a wage change. Answer a describes the substitution effect, and answer b describes the scale effect. Note that answer c simply repeats, using different words, the idea that the demand curve is downward sloping. It does not answer the question since it does not give an economic reason for the relationship. 10. Answer d. The demand curve as shown on the graph has a vertical intercept of 36 and a slope of 3, which implies that the equation is W = 36 3L L = W 11. Answer c. When the price of capital rises, the firm will substitute relatively cheaper labor for capital (substitution effect). The optimal output of the firm will also fall, however, leading the firm to use less of all its inputs (scale effect). As long as the substitution effect dominates the scale effect, the quantity of labor demanded will increase and the demand curve for labor will shift to the right. (Note that a reflects a change in the quantity of labor demanded, or a movement along the curve, not a shift in the curve.) 12. Answer b. The market supply curve is drawn holding working conditions and wages in other occupations constant. Wages in other occupations need not be at any particular level for the supply curve to be drawn. The presence of a union may mean that not all of the S curve will be relevant, but it would not change the fact that the market supply curve shows the number of workers willing to work at all the various wage levels. 13. Answer b. The supply curve as shown on the graph has a vertical intercept of 6 and a slope of 2, which implies that the equation is W = 6 + 2L L = 1 2 W Answer b. Individual firms offering comparable jobs in a competitive labor market will be constrained to pay the market clearing wage. In this case, an individual firm will be able to hire as much or as little labor as it wants at a wage of $ Answer d. At any wage other than the market clearing wage, a shortage (excess demand) or a surplus (excess supply) will create a tendency for the wage to change. Also, when the wage is not at its market clearing value, an opportunity for mutually beneficial exchange between workers and firms will exist. Hence once the market clearing wage has been attained, all the mutually beneficial deals will have been made, and it will only be possible to make someone better off by making someone else worse off.

3 Answers To Chapter Answer b. Economic rent is the triangular area abc in Figure 2-5. The area of a triangle is given by the formula Area = 1 (base) 2 (height) Economic Rent = 1 (6,000)($12) 2 = $36,000. Figure Answer c. With the wage fixed at $24, the supply curve effectively becomes a horizontal line at $24 and the quantity of labor demanded will fall to L = 12 1 (24) = 4. 3 Note that the surplus will actually be 5 since the quantity supplied will increase to Answer d. If the wage is originally at the market clearing level, then quantity demanded will equal quantity supplied. When demand increases, quantity demanded will now be greater than quantity supplied at the market clearing wage. This means that there is a shortage of labor and upward pressure on the wage. As the wage rises, the shortage is eliminated and a new higher market clearing wage is established. 19. Answer b. When demand increases, upward pressure is put on the wage and the employment level. When supply increases, downward pressure is put on the wage, and upward pressure is put on the employment level. As long as both supply and demand increase by the same amount, the pressures put on the wage will tend cancel out, while the pressures put on the employment level will reinforce. Thus employment will increase, but the effect on the wage depends on which shift is larger. If the shift in supply is greater than the shift in demand, wages will fall. If the shift in demand is greater than the shift in supply, wages will rise. 20. Answer b. L D = L S W= W W = 15 W * = $18. W * = $ (18) = 7. 3

4 246 Ehrenberg/Smith Modern Labor Economics: Theory and Public Policy, Tenth Edition Problems 21a. Unemployment rate = U E + U = 8%. 21b. While an 8% or higher unemployment rate is not unusual during economic downturns (e.g., ), it is fairly high by historical standards. Of course, it is nowhere near the peak unemployment of 24.9% experienced during the Great Depression! 21c. While the unemployment rate has tended to fluctuate less in recent years, the average unemployment rate seems to be slowly climbing. 21d. If the labor force (L) equals E + U, and the population (POP) equals L + N, then the labor force participation rate (LFPR) is LFPR = L POP = 62.5%. 21e. No, this is not an unusually high labor force participation rate. Throughout the 1980s and 1990s the rate has been higher. 21f. Since 1950 the overall labor force participation rate rose modestly from about 60% in 1950 to the just over 67% in 2000, but fell to 66% by Over this period, however, the labor force participation rate of men dropped significantly from nearly 87% to 73%, while the rate for women increased from 34% to about 60%. 21g. The type of work has been changing steadily from goods producing to private-sector services. 22a. The reason for computing an index of real wages is to make it easier to compare the real purchasing power of a worker s wage when product prices are changing. The steps carried out in computing the index essentially hold prices constant. Hence any change in the index reflects a real change in the worker s command over goods and services, purchasing power. Also, by expressing purchasing power as a percentage of the purchasing power enjoyed in the base year (which is then standardized to 100%) the index makes it easy to compute the percentage change in buying power over time.

5 Answers To Chapter b. See Table 2-6 for the index of real wages computed using 1980 as the base year. Table 2-6 Year Index of Nominal Wages Price Index Index of Real Wages c. Over the period 1980 to 1997, real wages declined by 6%. 22d. This change understates the change in real compensation per worker since compensation includes both wages and employee benefits. Increases in employee benefits could easily offset the decline in real wages and make for an increase in real compensation per worker. Additionally, the price index may overstate the rate of inflation by ignoring substitution and changes in the quality of goods. 23a. Equilibrium L D = L S W = 1 2 W W * = $10. W * = $10 L * = 10 1 (10) = b. See the curves labeled D and S in Figure 2-6. The equilibrium wage and employment occur at point a. Figure c. At a wage of $6, the quantity supplied equals 3 (point b in Figure 2-6), while quantity demanded equals 7 (point c in Figure 2-6). The shortage of 4 units means that the market does not clear and that there will be upward pressure on wages.

6 248 Ehrenberg/Smith Modern Labor Economics: Theory and Public Policy, Tenth Edition *23d. Note that at a wage of $6, firms would like to hire a total of 7 workers, but only 3 individuals are willing to work. Suppose that one of the firms shut out of the market offers to hire an additional worker at a wage of $10. The demand curve indicates that firms would be willing to pay up to $12 for a fourth worker, so this firm would still gain $2 by the offer. On the other hand, from the supply curve it is clear that it would take only a wage of $8 to get the fourth worker, so this worker earns economic rent of $2. 23e. No, economic rent refers to the difference between what the worker actually earns and the minimum he or she would be willing to accept. A worker is only considered overpaid in an economic sense if the actual wage is above the equilibrium wage in the market. *23f. With the union restricting labor supply to 4 units, the supply curve becomes a vertical line at 4. This is line S in Figure 2-7. Figure 2-7 Equilibrium occurs where L D = L S W = 4 W * = $12. The equilibrium is point b in Figure 2-7. Since the equilibrium wage and employment level in the absence of the union was point a, the four members of the union who continue to be employed gain the area of the rectangle bcde for a total of ($2) (4) = $8. This gain comes at the expense of the firms. However, since one more worker could have been hired if the wage stayed at $10, there is also a loss of economic rent equal to the area of triangle aef. This area is equal to $1 (0.5 $2 1). 23g. The market demand for labor increases, for example, when the demand for the product the firm produces increases, when labor becomes more productive, when the price of capital falls and the scale effect dominates the substitution effect, when the price of capital rises and the substitution effect dominates the scale effect, or when the number of firms increases. The market supply of labor decreases, for example, when wages in other occupations increase relative to the occupation being considered, when working conditions in the occupation worsen, or when the number of workers in the area decreases.

7 Answers To Chapter Applications 24a. The unemployment rate decreases. Suppose that initially the number of unemployed workers is 3 and the number of people in the labor force is 9. Since the unemployment rate is the number unemployed divided by the labor force, the unemployment rate is 33.3%. If one of the unemployed workers drops out of the labor force, then the number unemployed would be 2 and the size of the labor force would be 8. Consequently, the unemployment rate drops to 25%. 24b. When the unemployment rate drops, as it would in this case, it usually indicates the labor market is getting tighter; that is, employers are finding it harder to fill positions, and prospects are improving from the workers perspective. In this case, however, even though the unemployment rate is going down, the labor market is actually getting looser. Workers prospects are declining and employers would be able to draw on an increasingly desperate pool of workers. *25a. No, it is not plausible to think that firms would desire to hire more workers at higher wage rates. An alternative conclusion is that the data reflect a series of equilibrium points (that is, both supply and demand are changing, or that demand is shifting, and thus the demand curve cannot be identified from the data). *25b. If the demand curve for this category of labor shifted to the right over time along a stable supply curve, one would observe the wage and employment level rising together. Such a situation is shown in Figure 2-8. Figure Since the net effect of the reduction in computer prices is projected to be a decrease in employment, the decrease in employment coming about through the substitution effect must be larger in magnitude than the increase coming about through the scale effect. 27a. An investment tax credit would have an ambiguous effect on employment opportunities in the industries where it applied. When the price of capital is reduced, firms have an incentive to substitute the relatively cheaper capital for labor (substitution effect). On the other hand, the reduction in the price of capital leads to a reduction in the firm s cost of producing another unit of output. This creates an incentive to expand output, and when a firm expands output, it uses more of all its inputs, including labor. 27b. Workers would see increased employment opportunities only if the positive scale effect associated with the investment tax credit exceeded the negative substitution effect.

8 250 Ehrenberg/Smith Modern Labor Economics: Theory and Public Policy, Tenth Edition 28a. This statement confuses a shift in the position of the demand curve (a change in demand) with movement along the demand curve (a change in quantity demanded). An increase in the supply of labor will cause the wage to fall, but this will lead to an increase in the quantity of labor demanded as the new equilibrium is established. The reduction in the wage will not cause a shift in demand as the statement suggests. 28b. Assuming the market is originally in equilibrium, when the supply of labor increases, an excess supply of labor is created at the current wage. This excess supply will put downward pressure on the wage. As the wage falls, the quantity of labor demanded by firms increases, and the quantity of labor supplied by individuals is reduced. The wage will stop falling when the excess supply has just been eliminated. At this new market clearing wage, the total level of employment will be greater than it was when the scenario began. The market supply of labor will increase, for example, when working conditions in the occupation improve or wages in other occupations fall relative to this one. Also, as the number of workers in a particular area increases the supply curve will shift to the right.

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