Problem_Set_3_Solutions

# Problem_Set_3_Solutions - Economics W3213 Spring 2010 Bruce...

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Economics W3213 Spring 2010 Bruce Preston Problem Set 3 Solutions Textbook Questions 1. Chapter 8: Exercises 13, 14: Solutions at the end of this document Short Answer Questions Indicate whether you think the following statements are true, false or uncertain. Support your answer by giving all necessary reasoning and calculations. 1. Workers expect to receive lower wages in the future due to a greater likelihood of reces- sion. These changed expectations induce a change in labor supply. The more elastic is the labor demand curve in response to real wage changes, the less the real wage must equilibrium. Solution: True A more elastic demand curve means that the demand curve is ±atter: a given change in the real wage induces a bigger change in labor demand the more elastic the demand. Now, reduced expectations about future wages represent an income shock to individuals. They are therefore likely to supply a greater number of hours at any given current wage - the supply curve shifts out. At the initial equilibrium wages there is excess supply of labor. To ration this excess supply, the real wage must fall, stimulating demand and reducing supply through the substitution e/ect. For the more elastic demand curve, employment demand will respond by a large amount as the wage falls, implying that the real wage falls b y less to clear the labor market. 2. Consider a country with a simple two-tiered income tax system. Individuals with income below an amount \$X pay no tax while individuals earning more than this amount pay 50 cents of tax for each dollar in excess of \$X. A government pursuing tax reform through changes in marginal income taxes can stimulate employment growth by reducing the top marginal tax rate. Solution: Uncertain There are several things to note. First if an individual earns less than the thresh- old level of income, \$X, then the change in marginal tax rate has no a/ect on labor supply. Second, if an individual earns more than the threshold, \$X, then there are two 1

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possibilities which depend on the relative magnitudes of the income and substitution e/ects of changes in wages on labor supply. The falling marginal tax rate increases the opportunity cost of leisure as an hour of work yields a higher wage. But the individual is also richer since taxes have fallen on all hours worked. This tends to reduce labor supply. Hence the e/ect of the tax reform would be ambiguous. Of course, on aggregate we generally assume that the substitution e/ect dominates the incomes e/ect, but it worth remembering these are only assumptions that require empirical validation and about which there is uncertainty. 3. Assume the labor market is initially in equilibrium and that wages change rapidly to en-
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## This note was uploaded on 02/27/2011 for the course ECONOMICS 201 taught by Professor P during the Spring '11 term at Columbia College.

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Problem_Set_3_Solutions - Economics W3213 Spring 2010 Bruce...

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