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Econ 339 Winter 2008 Problem Set 1 - Solutions

Econ 339 Winter 2008 Problem Set 1 - Solutions - Econ 339...

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Econ 339 Winter Quarter 2008 - Problem Set 1 - Solutions 1. Book Problems (p. 66): 1, 2 ,3 ,10 2-1. How many hours will a person allocate to leisure activities if her indifference curves between consumption and goods are concave to the origin? A worker will either work all available time or will not work at all. As drawn in Figure A, point B is preferred to points A and C . Thus, the worker chooses not to enter the labor market. As drawn in Figure B, point C is preferred to both points A and B . Thus, the worker chooses not to consume any leisure and to work all available time. Figure A Figure B 2-2 . What is the effect of an increase in the price of market goods on a worker’s reservation wage, probability of entering the labor force, and hours of work? Suppose the price of market goods increases from p to p and the person’s non-labor income is V . If she chooses not to work, she can purchase V/p units of consumption after the price change, whereas she could have consumed V/p units of consumption prior to the price increase. Thus, her endowment point has moved from E to E in Figure A. As long as leisure is a normal good, the indifference curve is steeper as we move up a vertical line, indicating that the slope of the indifference curve is steeper at E than at E . Thus, an increase in the price of goods lowers the reservation wage and makes the person more likely to work. Figure A. Hours of Leisure Hours of Leisure Goods Goods B C A A B C U 1 U 1 U 0 U 0
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Goods V / p V / p Hours of Leisure T 0 E E To simplify the illustration of the effect on hours of work, assume for simplicity that V = 0. The increase in the price of goods shifts the budget line from FE to GE , moving the worker from P to point R . This shift induces both an income effect and a substitution effect. The price increase in effect lowers the
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