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Econ 339 Winter 2008 Midterm Exam I - Solutions

# Econ 339 Winter 2008 Midterm Exam I - Solutions -...

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Northwestern University Department of Economics ECON 339 Labor Economics - Professor: Steffen Habermalz First Midterm Examination – February 6 th 2008 INSTRUCTIONS : Answer all questions. Make sure you show ALL your work. 1. Labor Supply & Demand: a. (10 pts.) Consider the relative price of labor and capital (w/r). What is the effect on long-run employment of a competitive firm if the relative price of labor decreases? Explain. A decrease in the relative price can come from three sources - a decrease in the wage MC decreases, output increases, Substitution Effect increases labor, Scale Effect increases Labor, Net Effect: positive - a increase in the price of capital MC increases, output decreases, Substitution Effect increases labor, Scale Effect decreases Labor, Net Effect: uncertain - a change in both prices that decrease the ratio Here the effect depends on the change in MC. a clear example is when both prices decrease but the wage decreases more, this implies that the scale effect is positive, substitution effect is positive anyway. Net effect: positive If r decreases and w increase (or vice versa) the effect on MC is uncertain, substitution effect still positive (we assume w/r decreases) Net effect: uncertain b. (10 pts.) Use the concept of the reservation wage to explain the effect of the Earned Income Tax Credit (EITC) on Labor Force Participation. If someone does not work his reservation wage (wage that leaves him indifferent between working and not working) is higher then the market wage. EITC artificially increases the person’s market wage by supplying him with a tax credit. The person will participate if the new “effective” wage

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