ECO405: Labor Economics
Instructor: Michael Rizzo
Problem Set #2
Exercises on Chapter 6
Distributed:
Wednesday, November 2nd, 2005
Due:
Friday, November 11th, 2005 – solutions will be posted on website
after class that day. If you had much difficulty and the posted
solutions don’t clear them up, be sure to see me!
For all of the following, assume people sleep 8 hours a day and allocate 16 hours per
day for leisure, work and work-related activities.
(1)
Draw the budget line if the non-labor income equals $100 and wage equals $10 per
hour. What is the opportunity cost of choosing one more hour of leisure?
(2)
Draw both the budget line and indifference curve showing a situation where an
individual chooses not to work. This is known as a “corner solution”- NOTE: the
solution does not involve a tangency point as it did previously in what are known as
“interior solutions”.
(3)
Using indifference curves and budget lines, show that a wage increase may induce
an individual to supply less hours to the labor market. Which effect dominates in
this case?
(4)
You just won the lottery. What does the income effect say will happen to your
hours of work? The substitution effect? Explain your reasoning clearly and
concisely.
(5)
Draw an indifference curve for a person that requires money income and leisure
hours in fixed proportions (e.g. for every hour of leisure she enjoys, she needs $50
of income – no more, no less).
(6)
If I tell you that there is a wage change and we see workers working fewer hours,
can you tell me about the relative shape of their indifference curves? Is the income
or substitution effect of this wage change on labor supply larger? Why? Explain in
words.
(7)
Suppose that the government is considering several options to guarantee that legal
services are provided to the poor.
(a)
All lawyers would be required to devote 5% of their work time to the poor
free of charge.
(b)
All lawyers would be required to provide 100 hours of work, free of charge,
to the poor.
(c)
All lawyers who earn more than $50,000 in a year would have to donate
$5,000 a year to a fund that the government would set up to hire lawyers (at
market wages) for the poor.

What is the likely impact of each option on the hours of work of lawyers?
(8)
Suppose we have no non-labor income. However, we have a wage offer of $20 per
hour. Draw the budget constraint. Now, suppose we have $50 per day of non-labor
income as well, draw the new budget constraint. Now, suppose that in order to
work we must pay for child care. This cost is not fixed, clearly the more hours I
work, the more hours I must keep my child in child-care. Assuming the child-care
market is competitive, if it costs me $10/hour for child-care, redraw my budget
constraint (ignore any time costs or other transportation costs).
(9)
Let’s consider two different methods of paying child support. Suppose before
divorcing, a father has $50 of non-labor income and a wage of $20 per hour. Now,
suppose he is divorced and must pay $40 per day in child support. Draw his new
budget constraint. What are the work incentive effects of this mandated support?
Suppose instead that he were able to keep all of his non-labor income, but that
every dollar per day he earns in the market would be paid in alimony until a total of
$40 per day is awarded. Draw this budget constraint. What are the work incentive
effects of this mandated support. Compare the impacts of the two programs.
(10) The first year of graduate school is incredibly intense for Economics PhD studentsthey take many classes with continuous exams, study day and night, learn more
math than anyone ever should, and watch their social life dwindle. At the end of
the year, they face a series of qualifying exams that must be passed to continue their
studies. The torture ends in mid-June and the students are expected to return in
mid-August for another intense but more reasonable year of work.
For some students, the Department offers a Fellowship that gives them what is
equivalent to $60 per work day over the summer. However, if the graduate student
takes a job with an outside firm during this two month period, the amount of the
Fellowship is reduced dollar for dollar (in other words if the student were to make
$200 over the summer, they would get $200 less in the Fellowship.) Assume that
the student could make $15/hr at a summer job.

Draw the budget constraint for the graduate student.

Show the optimal choice for a student who is really tired of working.
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
Would a graduate student ever work 3 hours a day? Explain.

Suppose you are a student that receives $60 from Cornell. If you worked 2
hours, how much money would you receive from your employer? How much
do you have to give back to Cornell? So how much money did you keep from
Cornell? How much monetary income do you have?

If you work the third hour, how much more money will you get from the
employer? How much more money would you have to give back to Cornell?
How much is your net gain in monetary income from working the third hour?
What is the slope of the budget constraint at these wages? Is this a
coincidence?

If you were working 6 hours, you would earn $90 from the firm and you
would have to return all $60 you received from Cornell. How much would
monetary income would you have? If you worked one more hour (7 total)
how much monetary income would you have? What is the marginal benefit of
working the 7th hour? What is the slope of the budget constraint?

What sort of behavior is the Department encouraging?
(11) Compare the labor force participation rates for high school dropouts, high
school graduates, workers with some college, and college graduates for
September 2005.
(12) Find me one piece of labor market data that indicates the economy is not doing
so well. Why did you choose this?
(13) Find me one piece of labor market data that indicates the economy is doing
well. Why did you choose this?
(14) One argument opponents of Wal-Mart often make is that Wal-Mart free rides on
government welfare payments – in that welfare payments enable Wal-Mart to
pay lower wages.
(a) According to the theory of labor supply we are learning, what must be the
labor market impact of welfare programs according to this story? How
does this story square with the theory you are learning and the empirical
evidence on the employment effects of welfare?
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(b) Opponents claims against Wal-Mart go something like this: “absent
welfare payments, workers “need” and therefore demand and get paid
from Wal-Mart – higher wages. “ In other words the supply of labor to
Wal-Mart would be lower in the absence of welfare payments. What two
factors MUST be true in order for workers to bid up their wages in the
absence of welfare payments?
(c) Therefore, for the claims of Wal-Mart opponents to be true, based on what
you answered in part (b), what MUST be true about the impacts of welfare
payments on potential Wal-Mart employees?
(d) Suppose now that neither of the events you describe in part c actually
occurs. Provide one possible explanation for why the presence of welfare
payments results in low-skilled workers earning LESS at Wal-Mart (this
may in fact be the only explanation).
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