ProblemSet_4_Solutions - ILRLE 240: Economics of Wages...

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CONTINUED ILRLE 240: Economics of Wages & Employment Professor Matthew Freedman Fall 2008 Problem Set IV Suggested Solutions 1. During his presidency, Ronald Reagan proposed lowering the minimum wage (which then stood at $3.35 per hour) during the summer months for teenagers. Reagan contended that doing so would boost employment among teenagers and help them to gain valuable work experience. The argument that lowering the minimum wage would improve the welfare of a group relies on what assumption regarding demand for low-skilled or inexperienced workers? The argument that lowering the minimum wage would improve the welfare of a group (e.g., teenagers) relies on the assumption of a high elasticity of demand for affected workers. Reducing the minimum wage would undoubtedly increase employment of low-skilled or inexperienced workers, but by how much depends on the elasticity of demand; employment would rise very little unless the demand for low-skilled or inexperienced labor is very elastic (the demand curve is very flat). If demand for low-skilled or inexperienced labor failed to increase much in response to a large reduction in the minimum wage, total income for the group could fall. Suppose, for example, that Congress lowered the minimum wage by $2 from $6 to $4 (a 40% reduction using the midpoint as the denominator 1 ) and that the reduction led to an increase in teenage employment by 20 from 90 to 110 (a 20% increase). This implies a labor demand elasticity of | η | = |0.20/-0.40| = 0.50 < 1 inelastic demand Total income for teenagers in this case declines: 110*$4 - 90*$6 = -$100 If employment were to rise to 180 from 90 in response to the 40% decrease in the minimum wage, though, | | = |0.67/-0.40| = 1.67 > 1 elastic demand Total income for teenagers in this case rises: 180*$4 - 90*$6 = $180 As this example suggests, only when demand for unskilled or inexperienced labor is very elastic will employment rise substantially in response to a reduction in the minimum wage, 1 There are two alternative specifications for the calculation of elasticities: the midpoint formula and the endpoint formula. In the midpoint elasticity formula, which is the one favored by Ehrenberg & Smith, percentage changes are calculated based on the average of the initial and ending values of each variable (rather than initial values). In the endpoint formula, on the other hand, percentage changes are calculated based on the initial values of each variable.
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CONTINUED and only when employment rises substantially will the welfare effects of a given minimum wage reduction be positive. Conversely, the more inelastic is labor demand (i.e., the less responsive is demand to price changes), the lower the likelihood that a decrease in the minimum wage will boost total labor income of low-skilled or inexperienced labor. 2.
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ProblemSet_4_Solutions - ILRLE 240: Economics of Wages...

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