Labour Economics - Fall 2018 Exam

Instructors: Michele Pellizzari

Teaching Assistant: Clemente Pignatti

Instructions: Please answer all questions in the booklets provided. You have 1.5 hours to complete the

exam. This is a closed-books exam but basic calculators can be used. The use of any other electronic

device is forbidden. Good luck!

PART A. Short questions

1. (25 points) What is the difference between unemployed and inactive individuals ac-
cording to the international standards in labour market statistics?

Solution: Unemployed individuals are not working, but are available to work and
actively searching for employment. Inactive individuals are not working who are
either or both unavailable to work and/or not actively searching for employment.

2. (25 points) Define the matching function and discuss its meaning.

Solution: The matching function is a relationship between the number of matches

(M ) formed in a given internal of time on the one hand and the number of un-
employed workers (U ) and the number of vacant jobs on the other (V ):

M = m(U, V )

It is usually assumed to be increasing and concave in both U and V . The matching

function captures the basic intuition of the search and matching approach that
only a certain number of unemployed workers will find a job in any given internal
of time whereas many other won’t find it due to the presence of a number of
frictions.
Labour Economics Fall 2018 Exam

3. (25 points) Explain briefly how David Card (ILR, 1990) identifies the effect of the
arrival of Cuban immigrants on Miami labour market. What effects does the author
find and how does he interpret them?

Solution: Exploiting the arrival of the Mariel Boatlift in Miami, the author does
not find any effect of the arrival of new immigrants on the labour market in
Miami (in terms of wages and unemployment). Two possible interpretations are
provided: (i) Cuban immigrants displaced other migrants from within the US
willing to move to Miami and (ii) great availability of jobs in low-skilled sectors
in Miami.

4. (25 points) List the two types of equilibria that can arise in the signalling model of
education and briefly explain in what way they differ.

Solution: The two equilibria are:

• separating equilibrium and;

• pooling equilibrium.

In a separating equilibrium workers with different levels of education are paid

different wages, whereas in a pooling equilibrium all workers are paid the same
wage regardless of their education.
Labour Economics Fall 2018 Exam

PART B. Long questions

1. (50 points) Consider a worker with the following utility function:

U = C 1/2 L1/2

and with a total endowment of weekly hours T = 40 and non-labour income V = 20.
Normalise the price of consumption goods and service to 1 and assume that the
market wage is w = 5.

(a) (10 points) Write down the worker’s budget constraint. Represent it graphically,
indicate what is its slope and its vertical intercept and explain their economic
meaning.

Solution: The budget constraint is:

pC + wL = wT + v

C + 5L = 5 · 40 + 20

C = −5L + 220

Hence, the slope is -5 and the vertical intercept is 220.

(b) (10 points) Derive the worker’s optimal choice of consumption, leisure and labour
supply. Represent the optimal choice on a graph.

Solution: The optimal choice is at the tangency point of the budget con-
straint and the map of indifference curves:

M UL
=w
M UC
C
= 5
L
Labour Economics Fall 2018 Exam

We can then replace C = 5L in the budget constraint yielding:

10L = 220

L = 22

and C = 110 and H = T − L = 18.

(c) (10 points) Consider now a change in the market wage from the previous w = 5
to w1 = 8. Write down the expression of the new budget constraint and represent
it graphically highlighting the differences with the old one.

Solution: The new budget constrain is:

C + 8L = 8 · 40 + 20

C = −8L + 340

Now the budget line is steeper (slope = -8) and the vertical intercept is higher
(340).

(d) (10 points) Derive the new optimal choice of the worker under the new budget
constraint.

Solution: The optimal choice is always at the tangency of the budget con-
straint and the map of indifference curves:

C
= 8
L
C = 8L

Replacing this into the budget constraint yields:

8L = −8L + 340

L = 21.25
Labour Economics Fall 2018 Exam

and H = 40 − 21.25 = 18.75 and C = 8 · 21.25 = 170.

(e) (10 points) Compute the income and substitution effect separately and represent
them graphically.

Solution: In order to disentangle the total change in optimal leisure (labour)

into the income and substitution effects, it is necessary to identify the point
at which the slope of the indifference curve of the new equilibrium equals
the slope of the old budget constraint. Such point satisfies two conditions:
1. utility equals utility in the new equilibrium (with w1 = 8), 2. the slope of
the indifference curve equals the old wage, i.e. w = 5.
1 1
Utility in the new equilibrium at w1 = 8 is: (170) 2 · (21.25) 2 ' 60.1. The
C
second condition requires L
= 5. Combining these two conditions yields:

1 1
(5L) 2 · L 2 ' 60.1

L ' 26.83

H ' 13.17

Hence, the income effect leads to an increase in leisure from 22 to 26.83 hours
and consequently to a reduction of labour supply from 18 to 13.17 hours.
Then, the substitution effect reduces leisure from 26.83 to 21.25 hours and
increases labour supply from 13.17 to 18.75.

2. Consider a perfectly competitive labour market with the following labour demand
(LD ) and labour supply (LS ):

1
LD = 200 − w
2
S 1
L = 20 + w
2

where w is the market wage. Assume the selling price of the firms’ output is equal to
1.
Labour Economics Fall 2018 Exam

(a) (10 points) Compute the equilibrium wage and the equilibrium level of employ-
ment. Represent the equilibrium graphically.

Solution: The equilibrium is reached when the demand equals the supply:

LD = LS
1 1
200 − w∗ = 20 + w∗
2 2
w∗ = 180

Replace this into either the supply or the demand equation to obtain the
equilibrium employment: L∗ = 110.

(b) (15 points) Assume now that the workers’ wages are subject to a lump sum tax
of 30. Compute the new equilibrium and represent it graphically.

Solution: If the workers have to pay 30 in taxes their labour supply becomes:

1
LS = 20 + (w − 30)
2

The equilibrium is derived as usual by equating supply and demand:

1 1
200 − w∗ = 20 + (w∗ − 30)
2 2
w∗ = 195

Eventually the tax is paid only partially by the workers as wages go up by

15 (from 180 to 195) and partially by the employers via higher wages. In
other words, firms will pay workers a wage of 195, workers will take home
195-30=165 and pay 30 to the State. The higher wage, however, leads to
lower employment: L∗ = 102.5.

(c) (15 points) Assume now that the same tax of 30 is levied on the employers
instead of the workers. In other words, employers are required to pay 30 to
the state for each worker they hire. Compute the equilibrium and represent it
Labour Economics Fall 2018 Exam

graphically.

Solution: Now the equation for labour supply is unchanged and it is the
demand of labour that changes as follows:

1
LD = 200 − (w + 30)
2

The equilibrium is derived as usual by equating supply and demand:

1 1
200 − (w∗ + 30) = 20 + w∗
2 2
w∗ = 165

For each worker employers will pay 165 in wage directly to the worker and 30
to the State. Overall the labour cost for the employers will be 165+30=195
and equilibrium employment will be equal to 102.5. Notice that the equilib-
rium is exactly the same as in the case when the tax is levied on the workers,
the only difference is in the formal requirement to pay.

(d) (10 points) Imagine that now labour supply becomes more elastic:

LS = 20 + 0.6w

Compared to the previous question, do workers end up paying more or less of

the tax burden?

Solution: Compute again the equilibrium equating supply and demand with
the tax levied on the employers:

1
200 − (w∗ + 30) = 20 + 0.6w∗
2
w∗ = 150

For each worker employers will pay 150 in wage directly to the worker and
Labour Economics Fall 2018 Exam

30 to the State. Overall the labour cost for the employers will be 180 and
equilibrium employment will be 110. Now workers are paying the entire tax.
Labour Economics Fall 2018 Exam

Labour Economics Final Exam

Please do not turn over your sheet until all students

have received their exam, and you have been

instructed to start.

You have 1.5 hours to complete the exam.

Good luck!