Economics 27 Professor Patricia M. Anderson

Practice Problem Set 2 Labor Supply and Compensating Differentials

Multiple Choice Questions

1. Reducing the fixed monetary costs associated with working may: a) cause an individual to work less. b) cause an individual to work more. c) increase the likelihood an individual will participate in the labor force d) lead to either a) or c)

2. The theory of compensating differentials predicts that: a) workers with poor conditions will always earn more than those with good conditions b) holding worker characteristics constant, workers with poor conditions will earn more c) holding wages constant, higher skilled workers will work under better conditions d) both b) and c) are true

Questions 3 and 4 refer to the following diagram, which illustrates the budget line for a worker (with 4000 possible hours in which to earn $5 per hour) both with and without a program similar to the Earned Income Tax Credit (EITC):

11k 10k

0 2000 4000 leisure

3. Consider an individual who would choose to work 3000 hours without the program. With the program, the individual will: a) definitely work more b) definitely work less c) only work more if the substitution effect is greater than the income effect d) only work less if the substitution effect is greater than the income effect

4. Consider an individual who would choose to work 1000 hours without the program. With the program, the individual will: a) definitely work more b) definitely work less c) only work more if the substitution effect is greater than the income effect d) only work less if the substitution effect is greater than the income effect Short Answer Questions

1. Draw a clearly labeled diagram that illustrates why janitors in hot, noisy factories might make $8 an hour, while janitors in air-conditioned office buildings might make $6 due to the presence of compensating differentials.

2. Suppose that the factory janitors are almost all men, while the office janitors are almost all women. The National Organization for Women (NOW) does a study showing that male janitors make more money on average than female. Briefly explain to NOW how the diagram in 1 implies everyone is utility maximizing. Make clear what important assumptions are being made.

3. Suppose NOW successfully lobbies for a law requiring all janitors to earn $8 per hour. Clearly illustrate in your diagram what effect this law will have on worker utility and firm profits. You can assume a firm will shut down if it is losing money.

4. Consider a parent, with $200 in unearned income per week, who can earn $10 per hour working between 0 and 60 hours per week. Draw a diagram that reflects the budget line faced by this average working parent. Be sure to properly label the axes.

5. Now suppose that if this parent decides to work at all, then high-quality day care will cost a fixed $100 per week. Adjust the budget line accordingly. Suppose this parent has a high marginal utility of leisure, and would work 20 hours without the day-care costs. What effect will these costs likely have on the amount of labor supplied? How would your answer change if the parent had a very low marginal utility of leisure? Refer both to your diagram, and to the role of income and substitution effects.

6. Now suppose a program is put in place to subsidize the cost of day care for parents working at least 20 hours per week. Suppose that as long as this parent earns less than $400 (i.e. works less than 40 hours), the full $100 cost is reimbursed. For those earning over $400 per week, the $100 rebate is reduced by $5 for every additional $10 earned (i.e. every additional hour worked), so that it is completely phased out for those earning $600 (i.e. working 60 hours). Draw a diagram that reflects the budget line with this new program in place. (Don't worry about being exactly proportional, just capture the main features of the program.)

7. Add some indifferences curves to the diagram for two different parents that would choose not to work without the program when faced with child care costs. Assume one parent has a relatively lower marginal utility of leisure than the other and clearly label which is which. Might this subsidy program have different effects on these two types of parents? Briefly explain.