You are to answer any combination of questions that sum to exactly 200 points.

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1 Instructions The questions below are arranged into two groups according to the estimated time and difficulty. Group A are relatively short, should require 5 10 minute each, and are worth 25 points each. Group B are more complicated, require more time (10 15 minutes each), and are worth 50 points each. The opportunity cost of answering one question in Group B is not answering two questions in Group A. You are to answer any combination of questions that sum to exactly 200 points. Group A: 25 point questions (estimated time 5 10 minutes) 1. Providing legal representation to individuals accused of a crime and unable to afford their own attorney is essential to our legal system. Evaluate the normative economic (Pareto efficiency) implications of the following two proposals to provide this representation. Assume that both proposals are expected to provide the same level (quality) of representation. Proposal 1: Require that all defense attorneys to participate in a program by which they are randomly assigned to provide free legal representation to such individuals. Proposal 2: Create a publicly financed office of attorneys that will represent these individuals. PROPOSAL 2: ATTORNEYS IN THE PUBLICALLY FUNDED OFFICE WOULD CHOOSE THIS EMPLOYMENT VOLUNTARILY. IT THEREFORE HAS ONE MAJOR ADVANTAGE OVER PROPOSAL 1, IN WHICH ATTORNEYS PARTICIPATION IS MANDATORY. UNDER PROPAOSAL 2, SOCIETY IS ASSURED THAT ATTORNEYS WHO WORK IN THE OFFICE VIEW THE JOB AS IMPROVING THEIR WELFARE; THAT IT IS THE BEST ALTERNATIVE AVAILABLE TO THEM. WHEN THE PROGRAM IS MANDATORY, AT LEAST SOME OF THE ATTORNEYS MAY CONSIDER OTHER ALTERNATIVE EMPLOYMENT AS SUPERIOR TO DEFENDING LOW INCOME DEFENDENTS. THESE ATTORNEYS WOULD BE FORCED TO PARTICIPATE IN A TRANSACTION THEY SEE AS DETRIMENTAL TO THEIR WELFARE. ALLOWING THESE ATTORNEYS TO CHANGE EMPLOYMENT WOULD IMPROVE SOCIAL WELFARE THROUGH THE REALLOCATION OF RESOURCES. THERE ARE TWO ISSUES THAT ARE NOT REQUIRED, BUT MAY BE OF INTEREST. ONE IS HOW THE FUNDS FOR THE PUBLIC OFFICE WILL BE RAISED. THE OTHER IS THE QUALITY OF THE REPRESENTATION MIGHT DIFFER UNDER THE TWO PROPOSALS, BUT THE QUESTION ABSTRACTS FROM THIS ISSUE.

2 2. One of the assumptions of the perfect completion model is that there are very low or no transaction costs in the market. In product markets this allows the marginal value consumers place on a product to equal the marginal cost to society of producing the product. a. Describe the analogous equivalency in the labor market. b. Evaluate the appropriateness of this assumption in labor markets. A. IN THE LABOR MARKET LOW TRANSACTIONS COST IMPLIES THAT WORKERS CAN CHANGE JOBS AT LOW COST AND THE FIRMS CAN CHANGE EMPLOYEES AT LOW COST. B. THERE TRENDS TO BE HIGH TRANSACTIONS COSTS IN MOST LABOR MARKETS. FIRST WORKERS TEND TO INCUR SUBSTANTIAL COSTS WHEN SWITCHING JOBS AND MOST FIRMS INCUR SUBSTANTIAL COSTS WHEN SWITCHING EMPLOYEES. THUS THE PERFECTLY COMPETITIVE MODEL DOES NOT FIT MANY LABOR MARKETS. 3. What data provided by the human resource department about the applications for job openings would make you infer that the pipefitters in your firm are overpaid? IF WORKERS ARE BEING OVER PAID THEY ARE PAID ABOVE THE MARKET; IN SUCH CASES ONE WOULD EXPECT OTHER PEPFITTERS TO WANT TO WORK FOR YOUR FIRM AND THERE WOULD BE A LONG LIST OF APPLICANTS FOR JOBS. 4. Assume the following data for a make-believe country. The adult population is 210 million; there are 130 million who are employed and 5 million are unemployed. a. Calculate the unemployment rate to one decimal point. b. Calculate the labor force participation rate to one decimal point. A. UE RATE = UE/LF = 5/135 = 3.7% B. LFPR = LF/POP = 135/210 = 64.3%

3 5. When Glenda graduated in May two companies offered her jobs, which were identical except for the salary. One company's salary offer was $32,000; the other's was $37,000. Assuming that both companies operate in competitive product and labor markets, what economic explanation can you offer for the willingness of the second company to offer Glenda a higher wage? SINCE THE VALUE OF GLENDA S LABOR TO EACH FIRM DEPENDS IN PART ON THE OTHER FACTORS OF PRODUCTION ALREADY EMPLOYED, THE ADDED VALUE THE SECOND COMPANY PLACES ON GLENDA S LABOR MAY IMPLY THAT THEY ARE CURRENTLY USING LESS OF HER TYPE OF LABOR THAN IS PROFIT MAXIMIZING, THUS SHE WOULD HAVE A HIGHER MRP FOR THE SECOND COMPANY THAN FOR THE FIRST. 6. Years ago, Great Britain adopted a program that placed a tax to be collected from employers on wages in service industries. Wages in manufacturing industries were not taxed. In your answers below, assume the labor demand curve is drawn with respect to the take-home wage of employees. a. Discuss the impact of this tax policy on the demand for labor in service industries. b. Discuss the wage and employment effects of this tax policy in service industries. c. Discuss the wage and employment effects of this tax policy in manufacturing industries. a. THE TAX INCREASES THE COST OF LABOR TO SERVICE INDUSTRY EMPLOYERS; THUS DECREASING (SHIFTING TO THE LEFT) THE DEMAND FOR LABOR. b. THE WAGE AND EMPLOYMENT EFFECT OF THIS DECLINE IN DEMAND DEPENDS ON THE ELASTICITY OF THE LABOR SUPPLY CURVE. THE MORE ELASTIC THE SUPPLY THE LARGE THE EMPLOYMENT EFFECT; THE LESS ELASTICE THE SUPPLY THE LAERGER THE WAGE EFFECT. c. THE IMPACT ON MANUFACTURING DEPENDS ON SEVERAL FACTORS, INCLUDING THE SUBSTITUTABILITY OF SERVICE LABOR FOR MANUFACTURING LABOR. ASSUMING THEY ARE SUBSTITUTES, THE SUPPLY OF LABOR TO MANUFACTURING SHOULD INCREASE. THIS WOULD TEND TO REDUCE WAGES AND INCREASE EMPLOYMENT. IF CONSUMER DEMAND FOR MANUFACUTRED GOODS (COMPARED TO SERVICES) INCREASES THIS WOULD FURTHER INCREASE EMPLOYMENT AND WOULD HELP TO CUSHION THE FALL IN WAGES.

4 7. Using the Hicks-Marshall rules for derived demand, explain why one would expect the short-run own-wage elasticity for demand for labor to be less elastic that the long-run own-wage elasticity for labor. HM 1: ELASTICITY OF PRODUCT DEMAND Usually the product demand is more elastic in the long-run, thus Ld would be more elastic in the long run HM 2: EASY OF FACTOR SUBSTITUTION Usually it is easier to substitute inputs in the long-run, thus Ld would be more elastic in the long run HM 3: ELASTICITY OF SUPPLY OF OTHER FACTORS Usually the supply of other inputs is more elastic in the long-run, thus Ld would be more elastic in the long run HM 4: % OF TOTAL COST There is little reason to believe this would explain the difference between short and long run elasticity of Ld.

5 8. Suppose the weekly market demand for labor is given by the following equation: L = 75 3W, (1) where L is the measure of labor usage (the number of workers employed per week) and W is the wage rate (dollars per hour). a. As the wage increases from $5 per hour to $20 per hour, how does the slope of the labor demand curve change? Support your conclusion. b. Calculate the own-wage elasticity of demand at three wage points: $5, $10 and $20 per hour. c. Given the own-wage elasticity of demand at a wage of $10, if the equilibrium market wage increases from $10 to $11 per hour will total labor income increase? Briefly explain. A. THE SLOPE OF THE DEMAND CURVE IS CONSTANT; IT IS A STRAIGHT LINE DEMAND CURVE. ITS SLOPE IS -3. B. OWN-WAGE ELASTICITY OF LABOR = % CHANGE IN L CAUSED BY A ONE % CHANGE IN WAGE. 3 a. POINT ELASTCICY - SLOPE*w/N: AT $5 = = ; AT $10 = = ; AT $20 = = b. ARC ELASTICITY (Δ L/Δw)*(Σw/Σ L): FROM $4 TO $6 = = 0. 25; FROM $9 TO $11 = = ; FORM $19 TO $21 = = C. IF OWN-WAGE ELASTICITY INELASTIC, TOTAL LABOR INCOME INCREASES AS THE MARKET WAGE INCREASES. THUS TOTAL LABOR INCOME INCREASES FROM $450 AT A WAGE OF $10 TO $462 AT A WAGE OF $

6 Group B: 50 point questions (estimated time minutes) 9. In a recent article Christiana Stoddard and Peter Kuhn study the impact educational reforms have had on work hours of teachers. 1 Suppose they used ordinary least squares regression to obtain the results reported in the attached Table 3. The data in this table represents the results of four (4) regressions; one for each set of years. a. How much of the variance in the dependent variable (for the years ) is explained by their regression? b. For the regression for years , which independent variable coefficients are statistically significant? [For which can we be confident that the coefficient is not zero?] c. What conclusion about the changing impact of unionization might you draw from the evidence in the table? d. From the data in the table, which variable would you conclude is most consistently important over time? What support can you provide? A. ABOUT 3 PERCENT (R 2 = 0.03) B. AGE AND NONWHITE ARE THE ONLY VARIABLES WTH t VALUES GREATER THAN C. THE SHARE OF TEACHERS COVERED BY UNION AGREEMENTS WAS SIGNIFICANT AND NEGATIVE IN BOTH THE AND REGRESSSIONS. IT IS NOT SIGNIFICANT IN BOTH THE AND REGRESSIONS. ADDITIONALLY, THE COEFFECIENTS ARE SMALLER IN THE LATER REGRESSIONS. THUS I MIGHT CONCLUDE THAT THE IMPACT OF UNION AGREEMENTS HAS DECLINED OVER TIME. D. WHILE BOTH AGE AND NONWHITE HAVE SIGNIFICANT COEFFICIENTS IN ALL REGRESSIONS, THE INFLUENCE OF THE NONWHITE VARIABLE SEEMS TO BE LARGER AND GROWING, AS COEFFICIENTS ARE LARGER AND INCREASE IN MAGNITUDE OVER TIME. 1 Christiana Stoddard and Peter Kuhn. Incentives and Effort in the Public Sector. Institute for the Study of Labor (Iza) Discussion Series Paper No The article is available electronically at:

7 27 Table 3: Teacher Hours and Personal Characteristics: Cross-Section Regression Coefficients, CPS Sample Age (.2459).7634 (.3648).0978 (.3978).6508 (.4288) Age (.1678).5168 (.1922).8877 (.2373).6405 (2378) Female (.1841) (.2732) (.2181) (.2169) Nonwhite (.3357) (.2296) (.4927) (.4227) Teacher has Advanced degree.1928 (.1814).0857 (.2837) (.2507) (.2886) Teaches in a Secondary School.6188 (.1504).4384 (.1458).7521 (.2312).3807 (.2422) Share covered by union agreement (statewide) (1.1799) (1.1797) (1.3052) (1.1958) R Number of observations 11,822 11,101 10,877 9,027 Dependent Variable: Total Usual Weekly Hours at Main Job. Standard Errors in Parentheses. All regressions a full set of interview month and year dummies. Data from the June, July and August CPS interviews were not used.

8 10. Assume the market demand for and the market supply of labor can be represented by: L d = w L s = w a. Determine the equilibrium wage and units of labor employed. b. What is the value of economic rent earned by workers? c. Suppose a minimum wage of $300 per unit of labor. Determine the new equilibrium level of labor employed. d. Has the net income of workers increased? Explain. A. Ld = w = w= Ls 0.75w = 160 w = $213.33; L = B. ECONOMIC RENT IS THE AREA OF ABOVE THE LABOR SUPPLY CURVE AND BELOW THE WAGE. GIVEN THESE FUNCTIONS, THAT AREA IS A RECTANGLE UP TO 20 WORKERS AND A TRIANGLE FROM 20 TO WORKERS. THE FORMULA FOR RECTANGLE IS THE BASE TIMES THE HEGHT; FOR A TRIANGLE IS ½ THE HEIGHT TIMES THE BASE. THE RECTANGLE IS 20* = ; THE TRIANGLE HEIGHT IS ; ITS BASE IS ( ) = THUS TOTAL ECONOMIC RENT IS 20* PLUS ½ (126.67*213.33) OR , = 17, [ON GRAPH AREA 0, 240, A, 20] C. AT A WAGE OF $300 PER UNIT OF LABOR FIRMS WILL EMPLOY 125 UNITS (300) = = 125. D. THERE IS A NET INCREASE IN LABOR INCOME OF $37,500 $31, = $ NET IMCOME IS THE DIFFERENCE BEWTEEN THE INCOME EARNED WITH AND WITHOUT THE MINIMUM WAGE. INCOME WITHOUT THE MINIMUM WAGE, THIS IS wl = $31, WITH THE MINIMUM WAGE LABOR INCOME IS wl = $300 * 125 = $37,500.

9 GRAPHICALLY: 300 B D A C

10 11. Consider a firm that buys its labor and capital in perfectly competitive markets and has monopoly power in the product market. It has the following production and cost functions. Production function: Marginal product of labor: Fixed capital: 3 units Price of capital: $5 per unit Q = 2KL MP L = 2K Labor market supply: W = 24 Product market demand: P = 64 Q Profit maximizing rule: MRP L = MEL a. Calculate the Marginal revenue product of labor (MRP L ) b. Determine the short-run profit maximizing labor usage. c. What are the firm s resulting output, product price, and profits? d. Explain how an increase in labor productivity would impact demand for labor? Be sure to discuss the mechanism by which increased labor productivity changes demand and the direction of the change. A. Calculate the Marginal revenue product of labor (MRP L ) NOTE: TR = P * Q = 64Q Q 2 THUS, MR x = 64 2Q = 64 2(2KL) = 64 2(6L) = 64 12L MP L = 2K = 6 MRP = MP * MR x = (6) *(64 12L) = L L L B. Determine the short-run profit maximizing labor usage. MRP L = ME L L = = 72L L = 360 / 72 = 5 LABOR UNITS C. What are the firm s resulting output, product price, and profits? IF L = 5, THEN Q = 2K L = 6*5 = 30 UNITS PER TIME PERIOD; P = 64 Q = = $34 PER UNIT; PROFIT = TR TC = P*Q [VC + FC] = [30*34] [(3*5) + (5*24)] = 1020 [ ] = $885 D. Explain how an increase in labor productivity would impact demand for labor? Be sure to discuss the mechanism by which increased labor productivity changes demand and the direction of the change. THE INCREASED PRODUCTIVITY INCREASE THE MRP (SINCE MRP = MP * P), THUS INCREASING THE DEMAND FOR LABOR.

11 12. A recent federal law requires insurance policies to increase their coverage of mental illness so it is on par with physical illness. For example, if the policy covers hospital stays up to a maximum of 10 days per incident for operations, then it must provide up to a maximum of 10 days hospitalization per mental illness episode. Since many firms provide health insurance for their employees, this will increase the cost of labor. To keep your answer manageable, assume there is a single market for labor and a single market for the output of the firms. a. Explain the impact on the demand of labor in those firms which provide health insurance for employees. b. Explain the impact on the demand for labor in firms that do not provide health insurance for employees. c. Explain the impact on the price of output to consumers after they are able to adjust to the changes (long run). A. IN FIRMS THAT PROVIDE HEALTH INSURANCE THE INCREASED COST OF LABOR WILL REDUCE THE QUANTITY OF LABOR DEMANDED (IF THE DEMAND CURVE IS DRAWN WITH RESPECT TO THE COST TO THE FIRM). [IT WILL SHIFT THE DEMAND CURVE TO THE LEFT IF DRAWN WITH RESPECT TO THE TAKE HOME WAGES RECEIVED BY WORKERS.] B. SINCE THIS POLICY WILL HAVE NO IMPACT ON THE LABOR COSTS OF FIRMS THAT DO NOT OFFER HEALTH INSURANCE, THERE WILL BE NO DIRECT IMAPACT ON THEIR DEMAND. [THERE MAY BE SOME ON THE SUPPLY OF LABOR, SINCE THESE FIRMS OPERATE IN THE SAME LABOR MARKET.] C. THE COST OF OUTPUT WILL INCREASE FOR THOSE FIRMS PROVIDING HEALTH INSURANCE. THIS IS LIKELY TO CAUSE CONSUMERS TO ADJUST THEIR CONSUMPTION IN FAVOR OF THE OTHER FIRMS, THUS REDUCING THE OUTPUT DEMAND FOR THESE FIRMS. AS CONSUMERS SWITCH CONSUMPTION TO FIRMS THAT DO NOT OFFER HEALTH INSURANCE, THEIR PRODUCT DEMAND INCREASES DRIVING UP THE DEMAND FOR LABOR IN THOSE FIRMS. THE COMBINATION WILL LEAD TO HIGHER PRICES OF OUTPUT FOR CONSUMERS. EVEN IF YOU CONSIDER SUBSTITUTION OF CAPITAL FOR LABOR, THE COSTS OF PRODUCTION INCREASE AND EVENTUALLY INCREASE THE COST OF OUTPUT.