QUIZ 2: Macro – Winter 2013
Name:
___Answers___________________
Section Registered:
Tuesday a.m.
Tuesday p.m.
Wednesday a.m.
For questions 1a – 1f, circle the answer that makes the question stem true. When answering
the questions, you should only use the models developed in class (including assuming a
Cobb-Douglas production function). For each question stem, there is only one true answer.
Note: When answering these 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, all other exogenous variables are held fixed..
Question 1 (2 points each – 12 points total)
a.
A permanent increase in TFP will:
i.
Unambiguously lower before tax real wages.
ii.
Unambiguously increase before tax real wages.
iii.
Unambiguously have no effect on before tax real wages.
iv.
The effect on before tax real wages will depend on the size of the income
effect relative to the substitution effect on labor supply.
As we saw in Topic 3 and Supplemental Notes 5, a permanent increase in TFP (A) will
unambiguously increase real wages. An increase in A will start out by shifting the labor
demand curve to the right. To see this, we start with the Cobb Douglas production function:
Y = AK0.3N0.7. Taking the partial derivative with respect to N gives us: MPN = 0.7A(K/N)0.3.
Firm optimization results in MPN = W/P (this is our labor demand curve). From this
identity, we can easily see that an increase in A holding all else constant will shift the labor
demand curve up (or to the right). Using our labor market analysis, the permanent increase
in TFP will result in a permanent increase in W/P (when workers are more productive they
are more valuable to the firm). As we are richer, there will be a second shift in the labor
market. This second shift is a shift to the left of the labor supply curve (Ns). As we are
richer, the income effect on labor supply says we work less. This second shift will put
further upward pressure on real wages (as you and I leave the labor force, the remaining
workers become more valuable to the firm because of diminishing marginal product of
labor). So, both shifts reinforce each other and result in real wages increasing.
Two other things:
1.
If I asked you about what happened to the marginal product of labor (instead of
asking you about real wages), your answer would be the same. The reason for this is that in
our labor market equilibrium, MPN = W/P (this is the result of firm optimization). As long
as we are on our labor demand curve, the marginal product of labor will be equal to the real
wage. So, in this problem, MPN will unambiguously increase.
2.
In this problem, what happens to N* (equilibrium amount of labor) is ambiguous. It
depends on the strength of the substitution effect relative to the income effect. The
substitution effect is the movement up the original labor supply curve that occurs as labor
demand shifts out. In this case, N will increase. The income effect is the shift in of the
labor supply curve as real wages increase. In this case, N will fall. The net effect on N is
theoretically ambiguous.
b.
A permanent increase in TFP will:
i.
Unambiguously lower the marginal utility of leisure.
ii.
Unambiguously increase the marginal utility of leisure.
iii.
Unambiguously have no effect on the marginal utility of leisure.
iv.
The effect on the marginal utility of leisure will depend on the size of the
income effect relative to the substitution effect on labor supply.
Following the analysis of a positive TFP shock from the above question, we know the effect
on N is ambiguous. Therefore, what happens to the marginal utility of leisure is ambiguous.
Because of diminishing marginal utility of leisure, the marginal utility of leisure increases as
leisure falls. Leisure falls, when N increases. If the substitution effect dominates, the
marginal utility of leisure will increase (as N increases and leisure falls). If the income
effect dominates, the marginal utility of leisure will fall (as N falls and leisure increases).
Given I did not tell you what effect dominated, the answer is theoretically ambiguous.
c.
A permanent increase in labor income taxes will:
i.
Unambiguously lower the marginal product of labor.
ii.
Unambiguously increase the marginal product of labor.
iii.
Unambiguously have no effect on the marginal product of labor.
iv.
The effect on the marginal product of labor will depend on the size of the
income effect relative to the substitution effect on labor supply.
As discussed above, MPN = 0.7A(K/N)0.3. We also know, that MPN = W/P in equilibrium
(that is the labor demand curve). So, we only have to figure out what happened to W/P to
figure out what happened to MPN.
A permanent increase in labor income taxes will have NO effect on the labor demand curve
(labor demand is only a function of A and K (and oil prices - when we introduce them) - A
and K are held fixed unless I tell you otherwise per the question assumptions).
A permanent increase in labor income taxes will have two effects on the labor supply curve:
First, the labor supply curve will shift to the left because of a substitution effect (as taxes go
up, leisure becomes cheaper and we will substitute towards leisure). However, this will
lower after tax wages (this is why we work less). [Note: before tax wages will increase].
Now for the income effect: The decline in after tax wages will imply we are poorer. Given
this, the income effect says we should work more. This will be a shift out of the labor
supply curve. The net effect on the labor supply curve is theoretically ambiguous.
Given that we do not know how the labor supply curve will shift on net, we do not know
what will happen to N in equilibrium. If the income effect dominates, N will increase. If the
substitution effect dominates, N will fall. Additionally, we do not know what will happen to
before tax real wages. If N falls, workers are scarce and W/P will increase (because of
diminishing marginal product of labor). If N increases, workers are plentiful and W/P will
fall. Given that W/P is ambiguous, we know that MPN is also ambiguous.
The key to this question is to know that MPN = before tax real wage (W/P). Once you know
that, the question was straight-forward.
Note: In this problem, after tax wages unambiguously fall. That is the answer to part e. If
there is no income effect, we know that after tax wages fall (despite before tax wages
increasing). If there is a strong income effect, we know that before tax wages will actually
fall. In this case, we also know that after tax wages fall (because before tax wages fell and
tax rates went up). So, after tax wages are highest if there was no income effect. In that
case, we know that after tax wages fell. Any additional fall in before tax wages from an
income effect only reduces after tax wages more.
d.
A temporary increase in labor income taxes will:
i.
Unambiguously lower the marginal product of labor.
ii.
Unambiguously increase the marginal product of labor.
iii.
Unambiguously have no effect on the marginal product of labor.
iv.
The effect on the marginal product of labor will depend on the size of the
income effect relative to the substitution effect on labor supply.
The main difference between this question and the last question is that the tax change was
temporary. Temporary tax changes have no income effect. In this case, the labor supply
curve will unambiguously shift to the left (because of the substitution effect). We know that
before tax real wages will increase (as N falls). This means that the MPN will
unambiguously increase (workers are scarce so the remaining workers are more valuable to
the firm).
e.
A permanent increase in labor income taxes will:
i.
Unambiguously reduce after tax wages.
ii.
Unambiguously increase after tax wages.
iii.
Unambiguously have no effect on after tax wages.
iv.
The effect on after tax wages will depend on the size of the income effect
relative to the substitution effect on labor supply.
We can revisit our analysis from part C above. As discussed above, a permanent increase in
labor income taxes will cause the labor supply curve to shift in (via the substitution effect)
and cause the labor supply curve to shift out (via the income effect). For our analysis, we
should think carefully about which effect dominates.
If the income effect dominates, we know the labor supply curve will shift out which will
cause before tax wages (W/P) to fall. We also know that the government is taking more out
of each paycheck. These combined effects mean that after tax wages will be lower.
If the substitution effect dominates, we know the labor supply curve will shift in which will
cause before tax wages to increase. However, the government is taking more out of each
paycheck, so we know that after tax wages must be falling—that is why we are substituting
away from work (N wouldn't fall unless after tax wages are falling). Therefore, no matter
which effect dominates, we know after tax wages will fall as a result of a permanent tax
increase.
f.
A permanent increase in the working age population:
i.
Unambiguously lower the unemployment rate.
ii.
Unambiguously increase the unemployment rate.
iii.
Unambiguously have no effect on the unemployment rate.
iv.
The effect on the unemployment rate will depend on the size of the income
effect relative to the substitution effect on labor supply.
As we discussed in lecture and in several of the readings, unemployment results from a
disequilibrium of the labor market. A increase in working age population causes the labor
supply curve to shift out which will cause our labor market to reach a new equilibrium (not a
disequilibrium) at a higher N* and lower real wages (W/P). There is no disequilibrium;
therefore, there is no effect on unemployment as a result of this demographic change.
Question 2 (5 points)
Below, in italics, is a statement. You task in this section is to discuss whether that statement is True,
False or Uncertain. As on the practice exams - explanation determines all of your grade! We will
give no credit for writing true when the answer is true but your logic is wrong. Your answer should
not be longer than 3 well-constructed sentences.
Suppose there is a permanent increase in TFP. If the substitution effect on labor supply is
large relative to the income effect on labor supply, the permanent increase in TFP will shift
the labor supply curve (on-net) to the right.
So False!
Ideal Answer
False. The substitution effect from a permanent increase in A will move us along the original
labor supply curve. The income effect from a permanent increase in A will shift the labor
supply curve unambiguously to the left. So, the labor supply curve will unambiguously shift
to the left even if the income effect is small or large relative to the substitution effect.
Background For Your Answer
Let’s begin our analysis with the labor demand curve (ND). By now, you should know that an
increase in A causes an increase in MPN which will result in a shift out of the ND. As ND
shifts out, N will increase and real wages (W/P) will increase permanently (see question 1a
above). The substitution effect on labor supply will be the movement up the original labor
supply curve (the reason we are working more is because real wages increased).
As W/P increases, PVLR will increase. The income effect tells us that the labor supply curve
will shift in-- as we feel richer we work less.
Under no scenario, does the labor supply curve ever shift right. If there is no income effect,
the labor supply curve stays were it is. If there is any income effect (even if the income effect
is small), the labor supply curve will shift to the left.
Note (from Carolyn): Substitution effects from before tax real wage changes are
movements ALONG a labor supply curve. Substitution effects from tax changes (like tc or
tn) shift the labor supply curve. The reason for this is that after tax wages will change even if
before tax wages are held constant. We graph the labor supply curve in before tax real wage
space. That is why only changes in taxes (which change the after tax wage holding before
tax wages constant) shift the labor supply curve for a substitution effect. Any substitution
effect from a before tax real wage change is always a movement along a labor supply
curve.
Question 3 (3 points)
In the article “Why Businesses are So Slow to Fill Jobs” (Bloomberg.com - July 15, 2011),
Booth professor Steve Davis discussed his new research into why U.S. unemployment is so
high. Above and beyond skill mismatch and job seeking behavior by unemployed workers,
Steve and his co-authors focus on the decline in this type of “intensity” on the part of firms to
explain the low levels of firm hiring. What type of intensity declined sharply during the
recent recession according to Steve and his co-authors? Hint this activity was the subject of
the introductory figure that started the article. Your answer should not be more than three or
four words (with my preferred answer by only one word).
Recruiting intensity—we also gave you points if you conveyed the idea that firms were more
passive about seeking out talent or if you talked about uncertainty delaying firm hiring.