Department of Economics Spring 2007 University of California, Berkeley Prof. Woroch Economics 100APROBLEM SET 2 SOLUTIONS I. TRUE or FALSE and EXPLAIN: For each statement below, decide whether it is true or false, and explain the reasoning behind your answer in a few sentences. When appropriate, provide a diagram. 1.Francesca has a backward-bending labor supply curve because when she recently received an hourly wage increase, she voluntarily cut back on her hours—working fewer hours but earning the same amount. True. For a forward-sloped labor supply curve, we require that an increase in price (wage) would correspond to an increase in quantity (hours of labor – NOT money earned) supplied. Here, the price increase corresponded to a decrease in quantity supplied, hence the backward-bending labor supply curve. 2.If, in a two period world with a single good, consumption in the second period is a Giffen good, then the consumer will respond to a rise in the interest rate by saving less. True. The interest rate determines the relative prices of consumption in the two periods. To fix ideas, assume as we did in lecture that the nominal price of the consumption good (e.g., a loaf of bread) is $1 in both periods. The price of consumption in the second period, C2, is then 1/(1 + r). In that case, a rise in the interest rate lowers the price of C2. Because Csis a Giffen good, this lower price will result in lower consumption: C2falls. Necessarily consumption in the first-period consumption, C1, must rise. Remember that not all goods can be inferior, so since there are two goods in this story, and C2is inferior, C1must be normal. Increased C1automatically translates into decreased savings since savings is difference between money income and first period consumption. All of this can be shown in a picture: (1 + r’)I1 (1 + r)I1 I1 C2 C1 C*2 C*1 r’ > r I.EChange in savings < 0 S.E.
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