Economics 150
Fall 2003
Name________________
Labor Economics Midterm 1 Solutions
You have 1 hour and 15 minutes to complete this exam. There are 2 short answer questions, and
four true, false, explain questions. Write your answers on the pages provided. Show your work
for all your calculations. Each part of each question is worth 5 points.
1.
Overtime Pay
During the first gubernatorial debate, candidates expressed their opinions on California’s current
overtime pay policy. On September 4th, The Sacramento Bee reported, “McClintock and
Ueberroth opposed mandating overtime pay for workers after eight hours, a policy put in place
under the Davis administration, saying it unfairly burdened employers and took away flexibility
from workers; the other candidates supported it as a protection for hourly wage workers.”
a)
Consider a secretary who earns $12 an hour. She typically works 5 eight hour days a week
(40 hours per week), Monday through Friday. Draw a budget constraint and an indifference
curve for a single day of work, where this worker could work up to 16 hours, but chooses to
work 8 hours. Label the endpoints of the budget constraint, hours of work, and earnings.
Earnings
$264
$192
$168
4
6
8
16
8 hours labor
Leisure
b) Current California law says that if she works more than 8 hours in one day, her employer
would have to pay time and a half for the extra hours, and if she worked more than 12 hours
in one day, her employer would have to give double pay for each extra hour above 12 hours.
On your graph above, draw the new budget constraint that reflects overtime compensation.
Draw the indifference curve corresponding to the worker’s preferred hours of work each
day. Illustrate and describe the change in labor supply, and income and substitution effects
resulting from overtime compensation.
This worker would like to increase labor supply because of the potential to earn overtime pay.
Overtime leads to an income effect and a substitution effect. Because the worker feels richer,
she buys more of everything including leisure, and works less. The substitution effect says the
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Economics 150
Fall 2003
Name________________
increase in the wage increases the price of leisure, so the worker substitutes away from leisure
and works more. The overall effect on labor supply is somewhat ambiguous, but because the
overtime wage does not apply for less than 8 hours of labor, the worker will either increase hours
of labor, or not change them at all. The income effect takes the worker from 8 hours of labor to
about 7 hours of labor, on the line parallel to the original budget constraint, but tangent to the
new indifference curve. The substitution effect increases hours of labor from 7 to 10, moving
along the new indifference curve.
Earnings
$192
SE
IE
4
6
8
16
8 hours labor
Leisure
Expanded version to illustrate income and substitution effects.
c)
The secretary and her husband move to a new home, and she will now have a longer
commute. She still wants to work a 40 hour work week, but wants to commute only 4 days
a week, and work 10 hours each of those days. Her employer realizes that she can complete
all of her work during this time, and it would not be inconvenient, but he has to consider her
compensation. Should her employer willingly accept this change in her work schedule?
Explain.
If the employer has to pay overtime for the 2 extra hours a day, he would have to take this into
consideration when deciding whether to allow the flexible work schedule. This would be
expensive and he would probably choose not to have the employee work the flexible schedule.
California’s law does allow the worker to have an alternative work schedule as long as the
schedule does not total more than 40 hours a week, no more than 10 hours a day, and is agreed
on by the worker (or union) and the employer. Even with these regulations, there would
probably be a way to allow the worker to have this 4 day a week schedule.
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Economics 150
Fall 2003
2.
Name________________
Regression Analysis—Wages Depend on Education
In class we found the following regression coefficients explaining wages:
R-squared = 0.28
Intercept
Education
South
Black
Hispanic
Female
Married
Experience
Union
Coefficients
-4.18271
0.93713
-0.77142
-0.94239
-0.51239
-2.14066
0.485134
0.098486
1.468088
t Stat
-3.27823
11.34194
-1.79329
-1.61485
-0.56241
-5.4672
1.158167
5.629597
2.863248
The equation corresponding to these coefficients is:
Wage = -4.18 + 0.93(Education) - 0.77(South) – 0.94(Black) – 0.51(Hispanic)
– 2.14(Female) + 0.49(Married) + 0.09(Experience) + 1.47(Union)
a)
How much will wage change if years of education increases by 4?
4*0.93713 = $3.748
The wage will rise by $3.75.
b) List the variables that have statistically significant coefficients.
Education, Female, Experience, Union
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Economics 150
Fall 2003
Name________________
True, False, Explain. For each statement, answer whether the statement is true or false,
and then explain why it is true or false. Credit is given primarily for your explanation. Two
or three sentences should be sufficient to answer each of the questions.
1.
Economic theory tells us that the Earned Income Tax Credit creates income and substitution
effects that cause workers to increase hours of labor. True or false? Explain.
False. Theory tells us that the EITC creates income and substitution effects. The income effect
tells us that with the EITC, the worker will feel richer, buy more of everything including leisure,
and work less. The substitution effect can create different incentives, depending on the segment
of the budget constraint. In the phase-in range, the 40% subsidy is an increase in the price of
leisure, so the worker would substitute away from leisure and work more. In the phase-out
range, there is a 0.2106 reduction in the benefit for each dollar earned, so this effectively acts as
a tax, and reduces the price of leisure. The worker would substitute leisure for work, and work
less. The statement is false because the income effect always reduces hours of labor, and the
substitution effect sometimes reduces hours of labor.
2.
At the utility maximizing point, the wage must be equal to the worker’s marginal rate of
substitution of earnings for leisure. True or false? Explain.
True. At the utility maximizing point, the slope of the budget constraint (the wage) is equal to
the slope of the indifference curve (the MRS of earnings for leisure). At this tangency, the wage
must be equal to the value the worker places on trading an hour of earnings for an hour of
leisure.
3.
In 1996, the AFDC entitlement program replaced TANF, making it easier for poor families
to obtain and continue receiving welfare benefits. True or false? Explain.
False. In 1996, TANF replaced AFDC. TANF made it more difficult for poor families to obtain
and continue receiving welfare benefits, and ended the AFDC entitlement program. Now
families have to prove they are pursuing work related activities, and there are time limits on the
program.
4.
Social security is phased out for retirees who continue to earn more than $17,000 a year
through working. This would cause some potential retirees to delay their retirement. True
or false? Explain.
True. Workers may choose to delay retirement if they know that their benefits will be reduced if
they earn more than $17,000 a year after retirement. Consider someone deciding whether to
retire at age 62 or age 67. If he earns $50,000 a year and wants to continue working at least part
time, he realizes that if he officially ‘retires’ and starts collecting benefits at age 62, his benefits
will be reduced quite a bit because of the earning limit. He would probably be better off waiting
to retire until age 67, when his monthly benefit will be higher, and he will avoid having the
benefit reduced $1 for every $3 earned for those 5 years.
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