ECON 450 - Take Home Assignment 1

The Rules:
• This part of the quiz is due next Wednesday, April 22 in class.

• Quizzes turned in late will be penalized in proportion to the cost imposed on me. If I am
not inconvenienced, I won't impose a penalty.

• Make sure you put your name on the document you tum in.

• You may work with others in class; however, you are to tum in your own quiz and
include the names of all others who worked with you.

• The assignment you tum in should appear professional. Graphs may be drawn by hand,
but the rest of your assignment should be typed, papers should be stapled (or otherwise
bound), and your answers should follow the order of the questions.

1. Suppose your non-labor income was $25, your wage was $5 an hour, and the total
time available in the day was 20 hours: (1) draw your budget constraint for the labor­
leisure model; (2) solve for optimal amount of consumption and leisure given that
MUUMUC=(CIL) and indicate solution on graph; and (3) indicate the utility maximizing
hours of work.

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2. In 1993, Reynolds Tobacco Company won a contract to produce 14 billion cigarettes for
sale to Russia. Assume the company would like to induce its current work force to work
more hours per week in order to produce the extra cigarettes. Which plan is superior? The
Vice President of Production argues that a wage rate hike will induce employees to increase
their average workweek. On the other hand, the Director of Personnel argues that paying a
higher wage for overtime work is a surer method of getting employees to a work longer
workweek.
a) Graph the two proposals' budget constraints using a standard labor supply model.
Let the normal hours in a workweek be 40. Any work done beyond 40 hours can be
considered overtime work.
b) Which plan do you support? Why is it the better plan for achieving the goal?

Let BC I be the original budget constraint, BC A be the budget constraint under the Vice
President's proposal, and BCB be the budget constraint under the Director's proposal. The Vice

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 ECON 450 - Take Home Assignment 1

President's proposal mayor may not work. People may work more when wages go up or they
may work less. A positive substitution effect will prompt them to work more hours but a
negative income effect will prompt them to work less. So, the total effect (the effect we really
care about) is ambiguous depending on whether the magnitude of the substitution or income
effect is larger. The Director's plan has the exact same problem for workers already working 40
hours or more. However, those working less than 40 hours under the Director's plan may work
more; they definitely won't work less. Imagine a shallow indifference curve at H = 39. Under
the Director's plan, a higher level of utility on a higher indifference curve can probably be
achieved by working more hours. So, the Director's plan is probably better. His plan also
probably costs the firm less.

Consumption
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BC .. ..
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a
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Leisure 128 168

Hours of Work 40

3. Most real estate transactions pay realtors a commission of 6 percent of the sale of which
2 percent is paid to their real estate office. This translates to $25 an hour for the average
realtor. Recently, however, a firm called TREX has adopted a system whereby the realtor
pays the firm $50 a day upfront, but then keeps the full 6 percent commission or $37.50 an
hour for the average realtor.
a) Draw two budget constraints on the same graph for the average realtor working for
TREX and the "standard" real estate firm if there are 20 hours in the day to work or
leisure and nonlabor income is equal to zero.
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 ECON 450 - Take Home Assignment 1

b) There has been much complaining from "standard" real estate firms that TREX has
hired all of the "good" realtors. Use your graph in (A) to show that realtors who work
more than four hours a day for a standard firm would prefer working for TREX.

Mter 4 hours, TREX realtors earn more than standard realtors.

c) Use the concept of income and substitution effects to explain why realtors work
harder for TREX than for standard firms.

The substitution effect suggests that higher wages induce greater work effort.
Normally, income effects suggest higher wages lead to lower work effort; however, in
this case the $50 upfront fee, introduces a negative income effect that offsets the high
wage income effect. As such, income and substitution effects both push TREX realtors
to work more.

4. Reservation Wage: Use a diagram and the definition of the reservation wage to help
you explain how and why [the situation described below] can induce a worker to move from
an interior to a corner solution.
a) the birth of a child

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The birth of a child changes individual preferences for leisure and consumption. In
some cases, the desire to stay home with one's child will increase the MU of leisure
relative to the MU of consumption. When this occurs, the existing wage is not longer
sufficient to to the point where the MRS is steeper then the offered wage (pushing the
worker to a corner solution).

b) an increase in non-labor income when leisure is normal.

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An increase in non-wage income generates income effects which (because leisure is a

normal good) increase leisure (and reduce labor). A sufficiently large increase in non­
wage income will move the individual to the corner (and increase the wage required to
get the individual to work).
 ECON 450 - Take Home Assignment 1

5. For each of the following observed outcomes, offer at least 2 hypotheses that might explain
them:
a) The average wage for white males is higher than the average wage for black males.

Black males are discriminated against

Black males are less productive (e.g., they have fewer skills or obtain less education)

b) The average wage for urban workers is higher than the average wage for rural workers

The cost of living is higher in urban areas

Cities are less desirable places to live (e.g., due to congestion or crime) so workers

demand higher wages to live there.

Cities make workers more productive (e.g., they facilitate the transmission of skills

making workers more productive).

More productive (e.g., more highly educated workers) prefer to live in cities.

c) The average American works substantially more hours per year than the average

European.

Americans have stronger preferences for consumption (i.e., higher MUC) or weaker
preferences for leisure (i.e., lower MUL). This might arise due to differences in social
norms.

Taxes are higher in Europe than in the US and substitution effects are sufficiently strong that
lower after-tax wages yield fewer hours worked.

6. A university coffee shop has two types of workers: professional baristas (B) and
inexperienced student workers (S). The baristas are more highly skilled and experienced
than the student workers, but a student worker is able to do most elements of a barista's
job if given enough extra time. AB might be expected, baristas receive higher wages than
student workers. Suppose the wage for student workers increases due to a change in rules
for payments to student workers. How might we expect this to affect the employment of
student workers and baristas? Explain in terms of the scale and substitution effects we
discussed in class.

The substitution effect suggests that we should observe an increase in barista employment
(and a decrease in student employment) because they have become relatively cheaper.

The scale effect suggests that we should observe less employment for both baristas and
students. An increase in student wages increases the MC of production which reduces the
profit maximizing quantity of production (assuming MR remains constant).