Test Bank for Modern Labor Economics: Theory and Public Policy, 13th Edition, Ronald G.

Ehre

Test Bank for Modern Labor Economics: Theory and

Public Policy, 13th Edition, Ronald G. Ehrenberg
Robert S. Smith Ronald G. Ehrenberg Robert S.
Smith

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Answers to Chapter 6

• Review Questions
1. Answer d. Individuals can also affect their hours through working more than one job, vacations,
and leaves of absence.

2. Answer d. Typically when one observes indifference curves crossing on a graph, for example in
Figure 6-4, they represent the preferences of different individuals. If they pertain to the
same person, then the point of intersection simultaneously yields two different levels of
happiness, which violates the basic notion that the person can consistently rank different
combinations of leisure and income. Steep indifference curves indicate a high value for
leisure, since the person requires a large amount of income to offset a small sacrifice of
leisure.

3. Answer a. The wage rate is reflected in the slope of the constraint. Note that nonlabor income is
$200 and the optimal number of hours to supply is 100.

4. Answer d. When indifference curves are drawn with a convex shape, it ensures that when one moves
from an extreme combination (one where there is a lot of one good but not much of the
other) to one where the goods are more evenly consumed, a higher indifference curve
will be attained. In other words, the convex shape of the indifference curves is a way to
make the statement that people prefer variety to extremes.

5. Answer c. The objective of the consumer is not to maximize income or leisure but to find that
combination of income and leisure that is consistent with the budget constraint and leads
to the highest level of utility. Since higher indifference curves represents higher levels of
utility, maximizing utility can be thought of as trying to get on the highest attainable
indifference curve. Note that it is impossible for both leisure and income to be
maximized at the same point.

6. Answer d. When this condition holds, a window of opportunity exists for the individual to attain a
higher level of utility by moving to a point involving less than the maximum leisure time.
Very steep indifference curves can result in a corner solution.

7. Answer c. When work is viewed as something good, leisure implicitly becomes something bad.
Leisure is bad here when it exceeds 350 hours: when one gets more of it, income must go
up, not down, to keep the person at the same level of satisfaction. This creates the upward
slope to the indifference curves.

8. Answer c. Usually when the budget constraint has a flat segment, representing a guaranteed income,
the optimum occurs at the point of maximum leisure. But because after a point, leisure is
viewed as bad, the optimum occurs at 50 hours of work. The market wage is $4, with an
implicit tax of 100 percent on the first $400 of earnings, zero thereafter.
274 Ehrenberg/Smith • Modern Labor Economics: Theory and Public Policy, Thirteenth Edition

9. Answer b. For a person working zero hours, an increase in the wage cannot lead them to reduce
hours even further. So, although there is theoretically an income effect—if the person
makes any changes, her income will rise—in practical terms it must be dominated by the
substitution effect.

10. Answer a. If leisure were an inferior good, then the income effect associated with the wage increase
would actually cause the person to cut back on leisure. This, together with a positive
substitution effect, would ensure work hours would go up.

11. Answer d. Typically, goods do not switch from being normal to inferior, but even if they did, the
curve described in answer c could never turn back, since leisure being inferior guarantees
that portion of the curve would be upward sloping.

12. Answer a. Hours supplied should go up because such a change creates a pure substitution effect.
The lower marginal tax rate is like an increase in the wage, but the assumption that the
total taxes paid by workers remains constant means that income remained constant.

13. Answer a. A lump sum payment unrelated to earnings is an increase in nonlabor income that shifts
the budget constraint out parallel to the old constraint, thus creating a pure income effect.

14. Answer b. Scheduled benefits unrelated to earnings create a parallel shift of the constraint. Hence,
the opportunity cost of leisure remains the market wage rate, and so an incentive to work
is preserved.

15. Answer d. The maximum subsidy (S) is $600, and the breakeven income (S/t) is $1,200. Therefore,
the value of t must be 0.5. With an implicit tax rate of 0.5, the initial subsidy will be
completely “taken away” by the time earnings reach $1,200.

16. Answer d. The new optimum occurs at L = 350 (H = 50). The actual subsidy equals S – t(WH ) =
$600 – 0.5($200) = $500.

17. Answer b. The substitution effect is the movement from the point (L = 247, Y = $990) to the
point (L = 350, Y = $700).

18. Answer b. The income effect is the movement from the point (L = 200, Y = $800) to the point
(L = 247, Y = $990).

19. Answer b. As the implicit tax rate increases, the effective wage rate decreases, lowering the
opportunity cost of leisure, creating a substitution effect that pushes in the direction of
fewer work hours and an income effect that pushes in the direction of more.

20. Answer d. While reducing the implicit tax rate tends to preserve work incentives, it extends the
reach of the program (potentially to everyone if t = 0). As more people are eligible for
the program, the cost of the program tends to go up.

21. Answer c. The lowest income recipients actually face an above-market wage, creating a substitution
effect in favor of working, working against the income effect allowing more leisure.
Without knowing about preferences, one cannot predict the net response. For higher
income eligibles, either a zero implicit tax, or a positive implicit tax on earnings exists, so
there is nothing to counteract the income effect, and a substitution effect may even
reinforce it, reducing work effort.
 Answers to Chapter 6 275

22. Answer d. Many who work for minimum wages do not live in low-income households, and although
their impact on work incentives may be positive (they are theoretically ambiguous), they
may result in reduced hours because of employer cutbacks. As noted in the text, subsidies
given to employers to hire low-income workers have not been very successful, and in some
cases appear to have worsened the target population’s chances of finding employment by
identifying them as potential problem employees.

• Problems
23a. See the solid line in Figure 6-9.

Figure 6-9

23b. See the dashed line in Figure 6-9.

23c. Increased appreciation for leisure relative to income tends to make the indifference curves steeper. It takes
larger amounts of income to compensate for a given sacrifice of leisure.

24a. See the solid line in Figure 6-10.

Figure 6-10
276 Ehrenberg/Smith • Modern Labor Economics: Theory and Public Policy, Thirteenth Edition

24b. See the dashed line in Figure 6-10.

25a. Full income (WT + V ) for the original budget line is $2,700. Noticing that V = $300 and T = 400,
the original wage was $6. Similarly, after the wage decrease the new level of full income is $1,500,
which implies a wage of $3, given the same values of V and T.

25b. The income effect is the movement from the point (L = 225, Y = $1350) to the point (L = 177,
$Y = 1061), a decrease of 48 leisure hours. The substitution effect is the movement from the
point (L = 177, Y = $1061) to the point (L = 250, Y = $750), an increase of 73 leisure hours.

25c. The two points would be (W = $6, H = 175), and (W = $3, H = 150). The curve is positively sloped.
The substitution effect is stronger than the income effect in 25b.

26a. Given that preferences are represented by the Cobb–Douglas utility function, the expression for
the optimal level of leisure is
α WT + V
L* =
α+β W .
Substituting the values that apply before the injury yields L = 8 (H = 8), Y = $40, and U = 320.

26b. If all the income is replaced after an injury, then L = 16, Y = $40, and U = 640, a higher level of
utility than that attained while working.

26c. To keep the worker at U = 320, solve the equation (16)(Y ) = 320. This implies Y = $20. Therefore,
to keep utility constant, only 50 percent of the original income needs to be replaced. This whole
analysis, of course, assumes that all leisure time is identical. That is, leisure time obtained through
injury yields the same utility as leisure time taken while healthy. This may not be the case, for
example, if the injury is painful or limiting.

27a. Given that preferences are represented by the Cobb–Douglas utility function, the expression for the
optimal level of leisure is
α WT + V
L* =
α+β W .
(Note that both α and β = 1 in this example.) Substituting the values that apply before the welfare
program, the original optimum is 200 leisure hours (200 work hours).

With t = 1, the effective wage, given by the expression (1 – t)W, becomes zero and while we cannot
divide by zero, the optimum occurs at the maximum of 400 leisure hours (zero work hours).

With t = 0.5, the effective wage rate is $2. Combining this with $500 in nonlabor income yields an
optimum of 325 leisure hours (75 work hours).

With t = 0, the effective wage remains the market wage of $4. Combining this with the nonlabor
income of $500 yields an optimum of 262.5 leisure hours (137.5 work hours).

Summarizing, t = 1 implies H falls by 200, t = 0.5 implies H falls by 125, and t = 0 implies H falls
by 62.5.
 Answers to Chapter 6 277

27b. An implicit tax rate of zero preserves work incentives the best since the opportunity cost of leisure
remains the market wage. Hours of work still fall under such a program because of the income effect
of the subsidy, but there is no reinforcing substitution effect if implicit taxes do not reduce the
effective wage rate.

28a. The breakeven income occurs at the value S/t. So for constraint acdb we have 350/t = 350, which
implies t = 1. For the constraint aceb we have 350/t = 1400, which implies t = 0.25. Note that when
we can view the breakeven point graphically, the tax rate can be calculated as S/B = t, or in the two
cases here, 350/350 = 1 and 350/1400 = 0.25.

28b. For these preferences, t = 1 provides the strongest work incentives. The reason for this somewhat
unusual result is that when t is reduced, the reach of the program (as illustrated by the breakeven
point) is expanded dramatically. In this case, the person would not even have been affected by the
program with the high implicit tax rate. The lower rate, however, enables the person to be eligible
for the program and experience the income and substitution effects it creates.

29a. See Figure 6-11. The breakeven point occurs at L = 1,600 (H = 1,200) and Y = $6,000.

Figure 6-11

29b. Given that preferences are represented by the Cobb–Douglas utility function, the expression for the
optimal level of leisure is

α WT + V
L* =
α +β W .

Substituting the values that apply before the program is enacted yields an optimum of L = 1,400
(H = 1,400) and Y = $7,000. This is point a in Figure 6-11. The level of utility (denoted by U1)
is 9,800,000.

29c. Using the graph as a guide, it appears likely that the individual will be pulled into the program, even
though they are currently above the breakeven point. The optimal point appears to be the corner of
the constraint which occurs at L = 2,000, Y = $6,000. Notice that the level of utility at this point is
12,000,000. This represents an improvement over the original point. The optimum is identical to that
which would have been achieved if benefits were simply cut off once earnings reached $4,000. No
one who values both leisure and income would want to locate along the horizontal segment of the
constraint when moving to the corner of the constraint is possible.
278 Ehrenberg/Smith • Modern Labor Economics: Theory and Public Policy, Thirteenth Edition

• Applications
30a. See Figure 6-12. The breakeven point occurs at L = 175 (H = 225), Y = $900. The value of S/t =
200/0.4 = $500 in this case represents the additional income needed to reduce the subsidy to zero
once the person qualifies for the program. Note that in this case, however, the person does not
qualify for the program immediately, but rather works 100 hours, and hence earns $400, before
the usual type of income maintenance program begins.

Figure 6-12

30b. Given that preferences are represented by the Cobb–Douglas utility function, the expression for the
optimal level of leisure is

α WT + V
L* =
α+β W .

For α = 0.65, β = 0.35, the optimal combination before the program was L = 260 (H = 140),
Y = $560. This is point a in Figure 6-12. After the program, the person should end up at the
corner of the new constraint (point d ). Since the corner point has coordinates L = 300 (H = 100),
Y = $600, this represents a reduction in work hours of 40.

For α = 0.75, β = 0.25, the optimal combination before the program was L = 300 (H = 100), Y = $400.
This is point b in Figure 6-12. After the program, the person should also end up at the corner of the
new constraint (point d ). There will be no reduction in work hours.

For α = 0.85, β = 0.15, the optimal combination before the program was L = 340 (H = 60), Y = $240.
This is point c in Figure 6-12. After the program, the person should also end up at the corner of the
new constraint (point d ). This represents an increase in work hours of 40.

30c. While some people will reduce their work hours due to the income and substitution effects such
programs can create, the possibility of such individuals dropping out of the labor force is very
remote. Also, some individuals will actually increase their hours just enough to cross over the
threshold and qualify for the program’s maximum benefit. Such thresholds seem like a sensible
way to preserve at least some minimal work incentives.
 Answers to Chapter 6 279

31a. See Figure 6-13. The original earnings constraint is line ab. Under this EITC, the maximum
subsidy first occurs where earnings equal $9,000. This occurs where L = 1,500 (H = 1,500). This
is point c in Figure 6-13. The level of total income (including the government payment) will be
Y = $11,700 (point d). The maximum subsidy continues to be received until earnings = $12,000
(point e). This occurs where L = 1,000 (H = 2,000). Factoring in the subsidy, total income is
$14,700 at L = 1,000 (point f ). The breakeven point occurs when earnings equal $18,000 (point b).
Once the person has reached point e, an additional $6,000 in earnings at an implicit tax rate of 0.45
just eliminates the $2,700 subsidy ($6,000 × 0.45 = $2,700). To achieve the additional $6,000 in
earnings, the person must increase work hours (reduce leisure) by 1,000 hours.

Figure 6-13

31b. To the right of point d, the individual is accumulating income according to the formula

income = WH + .3(WH),
which makes the effective wage rate (the absolute value of the slope of the constraint) (1.3)(W)
which equals 7.8. To the left of point f, the effective wage rate is (1 – t)W, where t = 0.45. This
means that the absolute value of the slope is 3.3.

31c. A person originally at point g will experience both an income effect and a substitution effect. The
substitution effect will push the person in the direction of more work, while the income effect will
tend to counteract this. At low levels of work hours, however, the income effect tends to be
relatively small, and so it is likely that the substitution effect will dominate the income effect and
the person will work more.

31d. A person originally to the left of point c will tend to reduce work hours. The extent of the reduction
depends on whether the person originally worked more or less than 2,000 hours. If the person
worked more than 1,500 hours but less than 2,000 hours, he will experience just a pure income
effect. If the person worked in excess of 2,000 hours, he will experience reinforcing income and
substitution effects. Note for H > 2,000, the position of the constraint moves out at the same time
that it becomes flatter. This creates a strong incentive to work less, and many workers are likely to
end up near point f.
280 Ehrenberg/Smith • Modern Labor Economics: Theory and Public Policy, Thirteenth Edition

*32a. See Figure 6-14.

Figure 6-14

*32b. The 40 percent marginal tax rate applies after $1,000 in total income is reached. With nonlabor
income of $200, that income level is reached when L = 200 (H = 200). This is point a in
Figure 6-14. The tax reduces total income by 20 percent to a total of $800 (point b). The effective
wage rate (the slope of the constraint) is now (1 − t)W, where t is the marginal tax rate. To the
right of point b, the slope is (1 − .2)4 = 3.2. To the left of point b, the slope is (1 − .4)4 = 2.4.

*32c. Given that preferences are represented by the Cobb–Douglas utility function, the expression for the
optimal level of leisure is

α WT + V
L* =
α+β W .
Substituting the appropriate values leads to an optimum of L = 225 (H = 175), Y = $900 (point c)
before the tax. After the tax, the level of nonlabor income falls to $160 and the effective wage rate
is 3.2. Substituting into the L* expression again yields L = 225 (H = 175), but Y is now lower at
$720. There is no change in labor supply since the income and substitution effects of the tax change
have exactly canceled one another. This combination is point d. The person has paid $180 in taxes,
making for an average tax rate of $180/$900 = 20 percent.

*32d. What is the value of Y on the after-tax constraint when H = 400? H = 400 implies Y = $1800. When
total income is $1,800, the person pays $200 on the first $1,000 he earned, plus $320 on the next
$800, for a total after-tax income of $1,280. If WT + V = $1,280, and W is $2.4 and T is 400, the
implicit value of V is $320.

*32e. Making the appropriate substitutions into the L* expression yields L =112.5 (H = 287.5), Y = $1,350
before the tax program (point e). After the tax program, substitute W = $2.4 and V = $320 into the
L expression to find L = 133.33, (H = 266.67), Y = $960 (point f ). Hours of work are reduced
*

modestly because of the stronger substitution effect of the higher marginal tax rate. The total tax
paid is 20 percent of $1,000 plus 40 percent of $350, for a total of $340. Note that this is not the
difference between $1,350 and $960, since the $960 reflects the lower level of work hours that the
tax induced. The average tax rate is $340/$1,350 = 25.19 percent.
Test Bank for Modern Labor Economics: Theory and Public Policy, 13th Edition, Ronald G. Ehre

*32f. Significantly higher marginal tax rates can result in appreciable reductions in the
work hours of higher-income individuals.

33a. Given that preferences are represented by the Cobb–Douglas utility function, the
expression for the optimal level of leisure is
α WT
L* =
+V
α+β . W
With both fixed monetary and time costs of working it is as if V is only $100 and T is
370 hours. This leads to an optimum at L = 197.5 (H = 172.5) and Y = $790. This yields
a utility level of 156,025. This does exceed the utility associated with not participating
in the labor force since the combination L = 400, Y = $200 yields a utility level of
80,000.

33b. Telecommuting would return V to $200 and T to 400, leading to an optimum at L = 225 (H
= 175) and Y = $900. Utility would now be 202,500. In this example, telecommuting leads to higher
levels of leisure, work, income, and utility.

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