Midterm 2 Answer Key - Spring 2010

# Midterm 2 Answer Key - Spring 2010 - Economics 1480 spring...

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Economics 1480 – spring 2010 midterm 2 – ANSWER KEY Directions: Please place your final answer in the space provided below. Partial credit will be given in problems A and B for work that is both carefully done and legible. Good luck! NOTE: Each of the four problems is worth 25 points, including 1 free point per problem. Problem A [25 points]: Suppose that Lola is deciding how many hours to work. She is endowed with 60 hours of time per week and can devote those hours towards working or leisure (L). Before any taxes or transfers, Lola’s wage rate (w) is \$15; these earnings fund consumption (C). 1) Sketch her budget constraint below; be sure to label the vertical intercept. [6 points] Lola’s original budget constraint BC 1 is simply a straight line from (L,C) = (60, 0) to (0, 900). This is because if she works 0 hours (= 60 hours of leisure), she earns \$0. If she works for 60 hours (= 0 hours of leisure), she earns 60 hrs * \$15/hr = \$900. 2) Now, suppose that the government implements an earned income tax credit schedule: EITC = 0.5 × labor market earnings for weekly earnings up to \$150 Between \$150 and \$300 of weekly earnings, the credit remains at its maximum level. Between \$300 and \$450 of weekly earnings, the credit is phased out at the same rate it was phased in. Thus, the credit is fully phased out once weekly earnings reach \$450. Add the budget constraint under EITC to the above graph. On the graph above, also draw two indifference curves for an individual for whom the EITC encourages labor supply. [6 points for EITC budget constraint, 6 points for indifference curves] (see next page for explanation)

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(This explanation refers to the graph on the previous page.) Under the EITC, Lola’s budget constraint is BC 2 , which coincides with BC 1 for L 30 (because if she is working for 30 or more hours per week, the EITC is completely phased out and does not affect her). The indifference curve IC 1 represents the highest level of utility that Lola can attain without the EITC (i.e., while on the budget constraint BC 1 ), with the point of tangency shown. Without the EITC, then, we can see that Lola consumes L 1 hours of leisure and thus works for (60–L 1 ) hours per week. With the EITC, Lola can attain the strictly higher level of utility represented by IC 2 . Now, she consumes L 2 hours of leisure and thus works for (60–L 2 ) hours per week. Since L 2 < L 1 , we have that (60 – L 2 ) > (60–L 1 ); that is, she works more under the EITC than she did before. 3)
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## This note was uploaded on 07/22/2010 for the course ECON 1480 taught by Professor Knight during the Spring '10 term at Brown.

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Midterm 2 Answer Key - Spring 2010 - Economics 1480 spring...

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