QUIZ 3: Macro – Winter 2010
Name:
______________________
Section Registered:
Campus
Evening
Question 1
Discuss whether the following statement (in bold below) is True, False or Uncertain. For
this question, your explanation determines your entire grade. For example, if you say
“true” and the answer is actually “true”, you will receive no credit unless your explanation
is correct. Your answer should be no more than three well constructed sentences. (4 points
total).
Consider the labor market developed in class. Suppose there is an unexpected permanent
increase in TFP. Suppose further that substitution effects on labor supply are greater than
income effects on labor supply. On net, the labor supply curve will shift to the right
when there is a permanent increase in TFP (in a world where substitution effects are
big relative to income effects).
False. Substitution effects on labor supply due to increases in the before tax wage are
represented as movements up the labor supply curve (i.e., movement along the labor
supply curve). Income effects on labor supply due to increases in the before tax wage
are represented by a leftward shift in the labor supply curve. If there are income
effects, the labor supply curve will ALWAYS shift left – regardless of the size of the
substitution effect. When we talk about the substitution effect being large relative to
the income effect, we mean that the movement up along the labor supply curve is large
relative to the leftward shift of the labor supply curve.
Key to the answer: You need to say that the labor supply curve will always shift to the
left when real wages increases – regardless of the size of the income effect relative to the
substitution effect (or that substitution effects from real wages increasing are
movements along the labor supply curve not shifts in the labor supply curve).
Note: This is a REALLY important question. I will definitely test this on the
midterm. If you are confused by this, you should definitely review last week’s lecture
and read (and review) supplemental notes 4.
Lastly, let me graphically illustrate this example so you see what is going on:
Ns(PVLR1)
2
(W/P)2
Ns(PVLR0)
1
(W/P)0
0
Nd(A1)
Nd(A0)
N0 N2
N1
(Sub effect – movement up Ns(0) from 0 to 1)
(Inc effect – shift in of Ns)
The net effect of a permanent increase in TFP is a rightward shift of the labor demand
curve which results in a movement up the initial labor supply curve (that is the
substitution effect). The labor supply curve will shift left (as PVLR increases – i.e., the
income effect). The net effect is an increase in N (from N0 to N2). N increases (i.e., the
sub effect of wages increasing is bigger than the income effect of wages increasing).
Instructions For Questions 2 and 3
For questions 2-3, circle ALL of the true answers to each of the question stems. When
answering the questions, you should only use the models developed in class. Each answer is
2 points.
Note: When answering questions, you should compare the initial position of the economy to
the new equilibrium in the economy (inclusive of both income and substitution effects). That
means, we will assume that the labor market will always clear. Lastly, unless I tell you
otherwise, assume TFP, tax rates, welfare programs, the capital stock, and the working age
population is held fixed.
Question 2
Which of the following are true about an unexpected permanent decline in labor income
taxes? For this question, assume that substitution effects on labor supply are of the same
magnitude as income effects on labor supply (8 points total – 2 points each).
We did this example in class. An permanent decline in labor income taxes will have
two effects. Effect 1 – a substitution effect (as after tax wages increase) that induces
individuals to work more – this is represented as a rightward shift in the labor supply
curve. However, as after tax wages increase permanently, we are permanently richer.
This will lead to effect 2 – an income effect that induces individuals to work less. This is
represented as a leftward shift in the labor supply curve.
In this problem, we assumed that the two effects cancel out (are of similar magnitudes).
In that case, the labor supply curve – on net – does not shift (it shifts right and then
shifts left by equal magnitude). The labor demand curve does not change at all (no
change in A or K). So, the net effect on N is zero (there is no change in N – the income
and substitution effects cancel out).
Given that N didn’t change (and A and K are held constant), there is no change in Y.
Also, because there is no change in either labor demand or labor supply, there is no
change in before tax wages (W/P). Given that W/P = MPN, there is no change in MPN
(marginal product of labor). This makes since that there is no change in N, A, or K –
MPN cannot change. We also know that W/P = .7 (Y/N). Given that W/P didn’t
change, we know that Y/N didn’t change. Again, this makes since given that both Y and
N remained constant.
Lastly, we know that after tax wages go up. After tax wages = before tax wages * (1 –
tax rate). As the tax rate fell and before tax wages increased, after tax wages must have
increased.
False – see above.
a.
GDP will definitely increase.
b.
After tax wages will definitely increase.
True – see above
c.
The marginal product of labor will definitely increase. False – see above
d.
The labor demand curve, on net, will shift left. False – see above
Question 3
Which of the following are true about a permanent increase in the working age population?
(8 points total – 2 points each).
We did this in class. Moreover, this question was on one of the practice quizzes (I
think).
Here is what we know. An increase in the working age population (immigration? baby
boom?) will definitely shift the labor supply curve to the right (this is just do to the fact
that more people are working). The shift had nothing to do with income or substitution
effects.
As labor supply increases, wages fall (we become less valuable to firms where there are
more of – holding A and K fixed). As wages fall, an income effect will induce us to
work more. This will also shift the labor supply curve to the right.
So, regardless of the size of the income effect, the labor supply curve will shift to the
right (note, the substitution effects are just the movements along the labor supply
curve). To prove this to yourself, suppose there are NO income effects. In this case, the
labor supply curve would still shift right because of the increase in population!
So, we know unambiguously (irrespective of the size of the income effect), that:
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The labor supply curve will shift right
The labor demand curve will not move (A and K are fixed)
N increases
Real wages will fall (as N increases)
MPN will fall (as N increases)
Y increases (as N increases)
Y/N falls (as W/P falls)
a.
On net, the labor supply curve will shift right if substitution effects on labor supply
are large relative to income effects on labor supply. True – see above
b.
On net, the labor supply curve will shift right if income effects on labor supply are
large relative to substitution effects on labor supply. True – see above
c.
The marginal product of labor will definitely fall regardless of whether or not
income effects on labor supply are large relative to substitution effects. True – see
above
d.
Output per worker will definitely fall regardless of whether or not income effects
on labor supply are large relative to substitution effects. True – see above