hw1 - University of Illinois at Urbana-Champaign Professor...

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University of Illinois at Urbana-Champaign Professor Ron Laschever, ECON 440, Spring 2011 1 Problem Set #1 Answer Key [I recommend reading it, even if you got full credit for a question] 1. Indicate whether each statement is true or false, and support your answer with a 1-3 sentence explanation. If part of a statement is false, then the whole statement is false. a. The unemployment rate will remain the same if a worker, after being fired from his job, decides to stay at home with his children, paint the house, build model cars, and does not pursue any paid employment. [10 Pts] False. The worker ceases being employed but does not become classified as “unemployed” because he does not look for a new job. The unemployment rate is the ratio of the number of unemployed people to the number of people in the labor force; the labor force is the number of employed plus unemployed people. The number of people who are employed falls by one person when the guy loses his job, the labor force falls by one person, and the number of unemployed people does not change. Therefore, the unemployment rate rises. This is discussed in Chapter 2.1 in the Borjas textbook. b. The argument that women’s labor force participation may fall as their husbands’ wages rise during the early stages of economic development is an example of the substitution effect. [10 pts] False. This is an example of the income effect. You might want to read the discussion in page 54 of the textbook. c. Consider a plan that pays people a credit (above their wage) for working. For example, I might get an extra 20% from the government if I actually go to work. The advantage of such a program is that it provides incentives for all recipients to increase their labor supply. (Note: The EITC which is an example of such a program is discussed in Section 2-11 of your textbook.) [10 pts] False. The EITC unambiguously provides an incentive for people who are out of the labor force to enter the labor force. But there is an income effect for people who are already in the labor force, which gives them an incentive to work less. In addition, there is a substitution effect which may lead people already in the labor force to work more or work less, depending on which part of the EITC budget constraint they are on. 2. Fun with budget constraints: Understanding how different policies affect individuals’ budget constraint is the key to understanding how the policies affect incentives. This problem asks you to draw slightly more complicated budget constraints than those we did in class and to analyze their effects on labor supply. Begin by drawing an individual’s
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hw1 - University of Illinois at Urbana-Champaign Professor...

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