Economics 151A Professor David Neumark Problem Set 2 - Solutions 1.

Suppose an individual's utility function over income (M) and leisure (L) is U(M,L)=M + 2L. a. Graph a few indifference curves. Answer: The solid lines in each graph below are indifference curves (for U=2T and U=2.5T).

b. Suppose that non-labor income is Y = 0, and the wage is w = 2.5. Draw the budget constraint on the same graph. Answer: Budget constraint (income is unearned income plus earned income): M = Y + w(T L) = 2.5(T L) . This is shown in the first graph above. c. Does this individual decide to work in the labor market? Explain using your graph. Answer: In the graph above with a wage of 2.5, the individual chooses no leisure and thus a labor supply equal to T (since Ls= T-L=T). You can see this as the pair (L,K) in the first graph. Any other point on the budget constraint is on a lower indifference curve. By not choosing any time for leisure she is able to achieve the highest level of utility (reaches the highest indifference curve on the graph). She chooses only to work because the ratio of marginal utility of leisure to the marginal utility of consumption is lower than the wage,

MU L < w. MU M

d. Now suppose wages are taxed at a 40% rate. What is the after-tax wage? Does this individual continue to work in the labor market? Explain using a graph. Answer: Let w be the pre-tax wage. We know w = 2.5. Tax = 40% of wage = 0.4w So after-tax wage w = w 0.4w = 0.6w = 0.62.5 = 1.5.

The graph above shows how the tax flattens the budget constraint by lowering the net wage. Under the tax, the individual chooses not to work (leisure is equal to T, therefore LS=T-T=0). You can see this as the pair (L,K)' in the second graph. Any other point on the budget constraint is on a lower indifference curve. Now the ratio of marginal utility of leisure to the marginal utility of consumption is higher than the wage,

MU L > w. MU M

2. Suppose that women suffer from discrimination in the labor market, which lowers their wages relative to those of men. What are the effects of such discrimination on women's labor force participation decisions, and labor supply (hours) decisions if they work? Use graphs to help answer the questions, assuming that indifference curves are convex. Answer: The answer here is not as simple as it may seem. Discriminatory wages are lower than they would be without discrimination, which means that the slope of the budget constraint women face is also lower under discrimination. The decrease in wages, however, could have different effects on womens labor supply choices because of differences in preferences and unearned income. Three factors may affect a womans labor supply decisions: preferences, unearned income, and wages. Figures 1 and 2 show how preferences are important. In Figure 1, a discriminatory wage ( w ) is associated with lower labor supply (i.e., the substitution effect dominates). In Figure 2, a discriminatory wage is associated with greater labor supply (i.e., the income effect dominates).

Figure 1

Figure 2

3. An individual has utility function over income (M) and leisure (L) of U(M,Y) = ML2. The amount of non-labor income is Y, and the individual has T hours available for work or leisure. a. Write an expression for the budget constraint, and show it in a graph. Answer: Budget constraint (income is unearned income plus earned income): M = Y + w(T-L).

b. Derive labor supply as a function of w, T, and Y. Answer: A utility maximizer will trade off leisure for income until the point at which the ratio of marginal utilities of the two is equal to the opportunity cost of the tradeoff, or the wage. That ratio of the marginal utilities is the marginal rate of substitution:

MRS =

MU L U / L 2 M L 2 M = = = MU M U / M L2 L

Setting the marginal rate of substitution equal to the wage, we have:

2M wL =w M = L 2
This satisfies the tangency condition between the indifference curves and the budget constraint, but doesnt require the budget constraint to hold. Therefore, we have to substitute into the budget constraint as follows:

M =

wL = Y + w (T L) 2
2 3

Solving for leisure, we have:

wL = Y + w(T-L) L = 2

( Y +T ) w

Finally, we can make this expression a function of labor supply:

2Y LS = T L = T 2 ( Y + T ) = 1 T 3 w 3 w
c. Is labor supply increasing or decreasing in w? Answer: Lets see by taking derivative w.r.t. w:

LS 2Y = 2 > 0. w 3w
Since unearned income and the wage are both positive, this derivative is positive and labor supply is increasing in the wage. d. Suppose T = 16, and Y = 10. What is the person's reservation wage? Answer: The reservation wage is the wage at which a person is just indifferent between working and not working. In other words, its the point at which optimal labor supply just equals zero. Using the labor supply equation above, we get:

2Y LS = 1 T 3 w

2Y 2Y 2 10 wres = = = 1.25 . =0T = w T 16

4. Workers' Compensation provides workers with replacement pay when they are injured on the job. Suppose workers have no unearned income, and that indifference curves are convex. a. Draw the budget constraint when Workers' Compensation benefits fully replace a worker's lost earnings (i.e., their earnings before the injury) while they are out of work, but takes away the benefit when they return to work. Answer: The person who is out of work and receiving Workers Compensation benefits of 100% of their income before the injury has income equal to M0 because he is spending all his time not working but still has income equal to that of when he was working. If he returns to work, his Workers Compensation benefits will immediately fall to zero and the budget constraint he will

face will be the same as before (assuming that he is fully recovered and can earn the same wage). In the graph below, suppose the pre-injury earnings are M 0 . Note that the budget constraint in not continuous at the maximum amount of leisure, T. At T, income is equal to M 0 , but as soon as the individual enters the labor force, total income falls to w(T-L) and this total income in the labor force is less than the benefit until solid part of the budget constraint reaches M 0 .

b. Suppose instead that the benefit is 50% of the worker's lost earnings, and the benefit is reduced by $.50 for every $1 of earnings when the worker returns to work. Draw the budget constraint, being careful to indicate the slopes of any portions of the constraint. Answer: In the graph below, suppose the pre-injury earnings are M 0 , so the benefit is M 0 / 2 . As soon as workers return to labor market, benefits become half of earnings until the budget constraint reaches M0 (i.e. until the benefits are exhausted). If the worker returns to work, these benefits will be taxed at a rate of and so the net wage is w - 0.5w = 0.5w. This results in the slope of the budget constraint being reduced by one half until the total Workers Compensation benefit is zero, which is at the original M0. After this point, the slope of the budget constraint will return to w. We can graphically see this as follows:

c. Suppose that workers who are injured on the job are sometimes partially disabled and unable to return to a job paying as high a wage as they earned before their injury. What are the incentive effects of the two options in parts a and b on labor supply? Answer: Under the first plan, a worker has the strongest disincentive to reenter the labor force. He would have to supply more labor in order to reach an income level that is equal to the size of the benefit, and earnings gain from working slightly more than he was before is tiny. There is a range of labor supply that yields an income less than the benefit, implying that a worker has no incentive to work at a lower pay job (since he would have to work more hours than before to exceed the benefits). Under the second plan, there is still some disincentive to reenter the labor force, but this disincentive is not nearly as strong as in the first plan. Workers are more likely to reenter the labor force once recovered from their injuries, since there is always an incentive to work. (There may be some workers still stuck at that kink point where labor supply is zero or at a lower labor supply, however.) d. What are the other costs and benefits of the two options in parts a and b? Answer: Under the first plan, covered workers may stay on the plan forever given certain preferences. The benefit for injured workers is that their income is fully replaced if injured. The cost of the second plan should be lower because of the smaller benefit and the hypothesized shorter term on the benefit. On the other hand, injured workers face a smaller income if they get injured. If the workers injury prevents any or most future work, this could be potentially risky. e. If workplace safety is in part responsive to the costs of sustaining an injury, which scheme (a vs. b) is more likely to help deter injuries?

Answer: Under the first scheme, workers have very little disincentive to avoid getting injured (other than that it might hurt a lot, but that is true under either plan). Under the second plan, workers have a greater incentive to work safely and avoid injury. Firms also face different incentives under the two plans, assuming they have to internalize the costs. Under the first plan, firms have an incentive to create safe work environments because their cost will be higher if workers are injured. Under the second plan, firms have less of an incentive to create a safe work environment because the plan has a lower potential cost. 5. The Earned Income Tax Credit (EITC) adds X% to earned income (I) over the range (0,I1) (the "phase-in range"), holds the income supplement fixed at I1(X/100) over the range (I1, I2) (the "stationary range"), and then reduces the supplement by 0.3( I - I2) for earnings greater than I2. a. Find an expression for the level of income I at which the supplement is eliminated. Answer: At earnings greater than I2, the total amount of the supplement is equal to I1(X/100) - 0.3( I I2). Setting this equal to zero, we have I = I1 ( X / 30) + I 2 , at which point the supplement is eliminated. b. For X = 40, I1 = $10,000, and I2 = $15,000, graph the credit C (i.e., the added income from the EITC) against income I, from I = $0 to I = $30,000. Answer:

c. For a worker with wage w = 10, and unearned income Y = $1,000, draw the budget constraint for annual hours of work, ranging from 0 to 2,000. Answer:

d. Using the budget constraint, show why the EITC is likely to induce entry into the labor force. Answer: Answer: The EITC increases the relative price of leisure. Since there is no income effect at the zero labor supply kink point, this change in the relative price makes it more likely that nonworking individuals will choose to work (again, given their preferences).

e. What is the extra tax rate at which earnings are taxed in the phase-out range? A U.S. Senator proposes to reduce this tax rate to weaken the disincentives to work. What happens if this tax rate is reduced to zero? Answer: During the phase-out range, earnings are taxed at a rate of 30%. If the tax rate is reduced to zero, then the government would be giving the maximum tax credit ($4,000) to everyone earning $10,000 or more. f. If the EITC encourages single women with children to enter the labor market, what are the potential consequences for wages of other workers? Answer: The wages of other workers will fall (just simple supply and demand in the labor market) in labor markets where these women will work. However, there may be hours reductions among women that offset these effects. 6. Suppose an individual's utility function over income (M) and leisure (L) is U(M,L)=ML, and the individual has non-labor income Y and earns wage w. The total amount of time available is 16 hours. a. What is the equation for the budget constraint? Graph the budget constraint. Answer: Budget constraint: M = Y + w(16-L)

b. Suppose Y = 0 and w = 2. What is the individual's utility-maximizing choice of M and L? Answer:

Set the marginal rate of substitution equal to the relative cost of leisure, w. MU L U / L M MRS = = = = 2 = w M = 2L MU M U / M L Then, substitute into the budget constraint, so 2 L = M = 2(16 L) L = 8 . This choice of leisure implies 8 hours of labor, or $16 earned income.
c. Now suppose Y = 10. If the individual works, what is the utility-maximizing choice of M and L? What is the individual's utility if she does not work? Does she choose to participate in the labor force or not? Answer: Take that last equation from part (b), and change the budget constraint: 2 L = M = 10 + 2(16 L) L = 5 + 16 L L = 10.5 . This choice of leisure implies 5.5 hours of labor, $11 earned income, and $21 total income. The utility of working is U (21,10.5) = 21 10.5 = 220.5 . The utility of not working is U (10,16) = 10 16 = 160 . Since the utility of working is greater than the utility of not working, she will choose to participate in the labor force. Note that the decision to work or not will be taken on by the individuals that are at the corner of the budget constraint. d. Now suppose there are fixed costs of working, such as expenditures on work clothes and transportation, and these costs are F = 5. Draw the budget constraint. Answer the questions in part c in this case. Do your answers change? Why?

Answer: Take that last equation from part (b), and change the budget constraint: 2 L = M = 5 + 2(16 L) L = 2.5 + 16 L L = 9.25 . This choice of leisure implies 6.75 hours of labor, $13.50 earned income, and $18.50 total income. The utility of working is U (18.50,9.25) = 18.50 9.25 = 171.125 . The utility of not working is U (10,16) = 10 16 = 160 . Since the utility of working is greater than the utility of not working, she will choose to participate in the labor force. In this case, the labor force participation decision has not changed with the fixed cost of working, but, at some larger fixed cost, this individual will decide not to enter the labor force. 7. Consider a family in which both the husband and the wife are making labor supply decisions. a. Suppose the husband is initially working, and his wage is increased. What is the predicted effect on his labor supply? Explain. Answer: This will depend on all the factors discussed in individual labor supply (i.e., how preferences determine the relative size of income and substitution effects). The income effect predicts a decrease in labor supply. The substitution effect predicts an increase in labor supply. b. Suppose the wife is initially not working, and her wage (the wage she is offered) is increased. What is the predicted effect on her labor supply (labor force entry decision)? Explain. Answer: If the wife is initially not working and the wage offered to her has increased there will be a substitution effect, but she does not experience an income effect because she was not initially earning any income. Her husband's income is similar to unearned income, creating a kink in her budget constraint. Just as before, some women will still choose to stay at the kink of the budget constraint to enter the labor market. However, for some women, the substitution effect

predicts that a wage increase will cause her to be more inclined to participate in the labor force now that the relative price of leisure has increased c. In part b, if the wife enters the labor market, can we predict the effect of the higher wage offered to the wife on her husband's labor supply? Why or why not? Describe a scenario about home production in which his labor supply is likely to increase, and a scenario in which it is likely to decrease. Answer: No, we cannot generally predict the cross-effects of wage in the household. If the non-market time of the husband and non-market time of the wife are substitutes in home production, then the husbands labor supply is likely to decrease as the husband starts doing the laundry, etc. If their times are complements in home production, however, then the husbands labor supply is likely to increase, as the marginal utility of his non-market time (previously spent, for example, playing bridge with his wife) has fallen.