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Department of Economics, CSUS Name:_____________________

Economics 150
Fall 2003
Problem Set 1
Due Tuesday September 16th at the beginning of lecture

Write all answers neatly on the pages given. Draw all graphs and write your answers in the space provided. Show all of
your work. You may discuss questions you have with other students, but your answers need to be in your own words.
Answers that appear to be copied from another student will receive a grade of zero.

Earned Income Tax Credit

The Earned Income Tax Credit offers a family with 2 or more children up to $4008.
Range 1, Phase-in: The credit is phased in at 40% of earnings up to $10,020.
Range 2, Constant: The credit is equal to $4008 from $10,020 to $13,090 of earnings.
Range 3, Phase-out: The credit is reduced 21.06 cents for every dollar earned above $13,090, giving
no credit to families earning more than $32,121.

a) Draw a budget constraint and indifference curve for a worker who earns $15 an hour, could work up
to 4000 hours a year, but chooses to work 2000 hours a year, if there is no EITC. Label endpoints of
your budget constraint.




2000 L2 4000

b) Draw a new budget constraint that includes the EITC. Draw a new indifference curve and label the
new approximate choice of hours of work.

Curves in bold. New choice of hours of work is 4000 L2, the new level of leisure.

c) Describe income and substitution effects caused by the EITC at this point on the budget constraint.

Income Effect: The worker feels richer, so buys more of everything including leisure and works less.
Substitution Effect: The price of leisure has decreased because the EITC benefit is taxed away 21 cents for
every dollar earned. So the worker buys more leisure and works less.

d) Would it be possible to create an income support program that did not cause any work disincentives?
Explain why or why not.
Department of Economics, CSUS Name:_____________________
Economics 150
Fall 2003
It would not be possible to create an income support program that does not cause work disincentives
because the support program would have to increase income, so there would always be an income effect
that causes hours of work to fall.

It would be possible to create an income support program that minimizes work disincentives where the
substitution effect causes people to want to work more. If we never have to phase out the income support
program, this will cause fewer work disincentives, but would be extremely costly because everyone could
qualify for the program even if their income is very high.

Employment Statistics

Total employment was 137.625 million in August 2003. 8.905 million Americans were unemployed. 74.977
million working aged adults were out of the labor force. 503,000 were discouraged workers.

a) How many Americans were in the labor force in August?

LF=E+U=137.625m + 8.905m=146.530 million

b) What was the labor force participation rate?

LFP = LF/Pop Pop = LF + OLF = 146.530m + 74.977m = 221.507m
LFP = 146.530m / 221.507m = 66.2%
c) What was the employment-population ratio?
Emp/Pop = 137.625 / 221.507 = 62.1%

d) What was the unemployment rate?

U rate = U / LF = 8.905 / 146.530 = 6.1%

e) Does the unemployment rate understate or overstate the unemployment problem? Why?
The unemployment rate understates the unemployment problem, because it does not include discouraged
workers. These are people who would like a job but are not currently looking for work.

Labor Supply and Demand

Using a labor supply and demand graph, illustrate and describe the effect of an increase in discouraged
workers on employment and wages. Will the increase in discouraged workers cause the unemployment rate
to increase?

An increase in discouraged workers will cause a reduction in the supply of labor. Discouraged workers are
people who were part of the labor force, but they stop looking for jobs, and will no longer be counted as part
of the labor supply. This causes the supply curve to shift back, reduces employment and causes wages to rise.

The increase in discouraged workers will not cause the unemployment rate to increase, and it could cause the
unemployment rate to fall, because workers who used to be counted as unemployed decide to exit the labor
force. If wages started above equilibrium, and there was unemployment, the unemployment gap could shrink
when the unemployed become discouraged and stop looking for work.
Department of Economics, CSUS Name:_____________________
Economics 150
Fall 2003
W S of Labor

D for Labor