Undergraduate Labour Economics:

Midterm II

Instructions.

• You have 70 minutes to complete this test.

• Write your name on your blue book and on the first page of the exam where it
says “Name”

• The exam is worth 120 points.

• Most questions can be answered independently of one another. For those that build, partial
credit is always available.

• To obtain full credit, make sure to explain your answers. Please write out numerical answers
in decimal form. In the calculations please keep at least two significant figures.

• The test is closed-book. You may use a calculator during the exam. You may not use any
printed or written material except this exam. Using any other electronic devices (such as
cell-phones, smartphones, tablets, laptops, etc.) is not permitted.

Name:

1
1. (25 points) Suppose we have two cities: Seattle and Los Angeles. Individuals expect to live
10 years and face an interest rate of 0% per year. Workers in each city have a yearly labour supply
given by h(w) = 8 (e.g., workers always work 8 hours a year). Firms face competitive input and
√
output markets and the yearly production technology of firms in each city is f (k, l) = 2 l and
firms get $20 per unit produced. Suppose that both Seattle and Los Angeles have 100 workers and
25 firms. Suppose that 50 workers in Los Angeles suddenly decide to “find themselves” in nature
and so leave the city to live in the forest (i.e., they disappear from our economy).

a. (10 points) After the mass exodus of people from Los Angeles, what will wages in Seattle and
Los Angeles be if people cannot move?

Answer: The firm side is the same for both cities. Start by setting up the firm’s maximization
problem and take FOC:

√
max 20 · 2 · l − wl
l
∂π 20
: √ =w
∂l l
 2
20 400
=⇒ l∗ = = 2
w w

Aggregate labour demand for both cities is L∗ = 25 ∗ 400

w2
= 10000
w2
. Aggregate labour supply is
H ∗ = 8 ∗ N . Wages are thus:

10000
8∗N =
w2
 0.5  0.5
∗ 1250 1250
=⇒ w = =
N N

Now can just plug in N for both cities to find wages:

 0.5  0.5
1250 1250
=⇒ wS∗ = = = 3.54
NS 100
 0.5  0.5
∗ 1250 1250
=⇒ wL = = =5
NL 50

So wages in LA are $5 and they are $3.54 in Seattle.

b. (15 points) After the mass exodus of people from Los Angeles, will wages in Los Angeles be
higher or lower than $4.50 if people face a moving cost of $50?

2
 1250 0.5


Answer: From part (a) wages from both cities are given by w = N . Because of the
exodus, wage in LA are currently $5. So people will be moving Seattle to LA until yearly wages
(hours worked per year times number of hours) over 10 years in LA (= 80wL ) minus the moving
cost, C, equals the wages over 10 years in Seattle (= 80wS ). So individuals move if:

80wL − C > 80wS

Let NL be number of workers in LA and NS number of workers in Seattle. From part (a) wages

0.5
from both cities are given by w = 1250
N . If wL = 4.50, then number of workers in LA is:

1250 0.5

4.50 =
NL
1250
=⇒ NL = = 61.73
4.502

Now note that there are only 150 workers in this economy and so it must be that NS + NL = 150.
So if wL = 4.50 then NS = 150 − 61.73 = 88.27. Wages in Seattle are then:
 0.5  0.5
1250 1250
wS = = = 3.76
NS 88.27

Now lets see if individual are still moving:

80wA − C > 80wM

=⇒ 80 · 4.50 − C > 80 · 3.76
=⇒ 360 − C > 300.8

Since C = 50, the above equation holds so people are still moving to LA from Seattle and so wages
∗ < 4.50.
in LA will keep falling. Therefore, wL

3
2. (30 points) Say that there are two types of individuals in the market, skilled and unskilled.
The yearly labour supply of all individuals is given by h∗ (w) = 5 (e.g., always work 5 hours). There
are currently 50 skilled and 50 unskilled workers in the economy. Labour markets are competitive
and firms sell their output for $10 per unit. There are 10 firms in the economy, each one with a
√ √
(yearly) production technology of f (ls , lu ) = 2 ls + lu where ls respresents the labour supplied
by skilled workers and lu the labour supplied by unskilled workers.

a. (10 points) Find the equlibrium wage of skilled and unskilled workers.

Answer: First note that aggregate labour supplies are Hs∗ (ws ) = 5Ns and Hu∗ (wu ) = 5Nu . Now
set up the firm’s problem:

p p
max 20 ls + 10 lu − ws ls − wu lu
ls ,lu

Now take derivative w.r.t. ls and lu :

∂π 10
: √ = ws
∂ls ls
100
=⇒ ls∗ = 2
ws
∂π 5
: √ = wu
∂lu lu
25
=⇒ lu∗ = 2
wu

Aggregate labour demand for each factor is then L∗u = 250

wu2 and L∗s = 1000
ws2
. To solve for equilibrium
wages then set labour demanded equal to labour supplied for each factor:

Hs∗ (ws ) = L∗s

1000
=⇒ 5 ∗ Ns =
ws2
 1
∗ 1000 2
=⇒ ws = =2
5 ∗ 50
Hu∗ (wu ) = L∗u
250
=⇒ 5 ∗ Nu =
wu2
 1
250 2
=⇒ wu∗ = =1
5 ∗ 50

4
b. (20 points) Suppose that (infinitely lived) unskilled workers could become skilled workers if
they get a union competency certificate. This certificate is granted immediately but costs $10.
Individuals have a discount factor of β = 0.95. Would the equilibrium wages of skilled workers be
above or below $1.7 in this economy? [Note: the wages you found in part (a) are yearly wages.
Also, take this question one step at at time, it is not as hard as it might seem at first glance!]

Answer: Start by finding the wage difference between skilled and unskilled workers that makes
workers indifferent between getting the certificate or not:

5ws 5wu
− 10 =
1−β 1−β
=⇒ 5(ws − wu ) = 10(1 − 0.95)
=⇒ ws − wu = 0.1

Next, find number of skilled workers (denoted by Ns ) required to achieve ws = 1.7:

Hs∗ (ws ) = L∗s

1000
=⇒ 5 ∗ Ns =
ws2
1000
=⇒ Ns =
5 ∗ 1.72
200
=⇒ Ns = = 69.2
1.72

Implying that there are 30.8 = 100 − 69.2) unskilled workers left in the economy. Their wage would
be:

Hu∗ (wu ) = L∗u

250
=⇒ 5 ∗ Nu =
wu2
 0.5
250
=⇒ wu = = 1.27
5 ∗ 30.8

So the wage differential between skilled and unskilled workers is $0.43 (= 1.70 − 1.27) which is a
large enough wage gap (as the wage gap where unskilled workers were indifferent between getting
a certificate or not was $0.10) that means less unskilled workers should keep becoming skilled,
creating more skilled workers, dropping the skilled worker wage to below $1.70 in this economy.

5
3. (40 points) Suppose that an individual lives for two periods. The individual (as per usual)
has 16 hours of time to devote to leisure or work in each period. The individual gets a wage of
$20 in period 1 and a wage of $25 in period 2. The interest rate in this economy is 10%. The
individual also receives a non-labour income of $10 in each period. The utility of the individual
depends on whether she is injured or not (as she really dislikes going to work if she is hurting).
Her utility in period t if she is unijured is given by u(ct , lt ) = 21 ln(ct ) + 12 ln(lt ) while it is given by
by u(ct , lt ) = 14 ln(ct ) + 43 ln(lt ) if she is injured. The individual also faces a borrowing constraint of
$40.

a. (15 points) Find the hours worked each period if the individual is uninjured in period 1 and
is able to predict that she will be injured in period 2 (e.g., injury is arthritis that she knows will
get worse in period 2).

Answer: Start by setting up the individual’s maximization problem:

1 1 1 3
max ln(c1 ) + ln(l1 ) + ln(c2 ) + ln(l2 )
l1 ,c1 ,l2 ,c2 ,s 2 2 4 4
subject to: l1 = T − h1
l2 = T − h2
c1 = w1 h1 + n1 − s
c2 = w2 h2 + n2 + (1 + r)s

Sub in budget constraints:

1 1 1 3
max ln(20h1 + 10 − s) + ln(16 − h1 ) + ln(25h2 + 10 + 1.1s) + ln(16 − h2 )
h1 ,h2 ,s 2 2 4 4

6
Take FOCs (and simplify each one down):

∂u 0.5 · 20 0.5
: =
∂h1 20h1 + 10 − s 16 − h1
=⇒ 160 − 10h1 = 10h1 + 5 − 0.5s
=⇒ h1 = 7.75 + 0.025s (1)
∂u 0.25 · 25 0.75
: =
∂h2 25h2 + 10 + 1.1s 16 − h2
=⇒ 100 − 6.25h2 = 18.75h2 + 7.5 + 0.825s
=⇒ h2 = 3.7 − 0.033s (2)
∂u 0.5 0.25 ∗ 1.1
: =
∂s 20h1 + 10 − s 25h2 + 10 + 1.1s
=⇒ 12.5h2 + 5 + 0.55s = 5.5h1 + 2.75 − 0.275s
=⇒ 0.825s = 5.5h1 − 12.5h2 − 2.25 (3)

Sub (1) and (2) into (3) to find s∗ :

0.825s = 5.5h1 − 12.5h2 − 2.25

=⇒ 0.825s = 5.5(7.75 + 0.025s) − 12.5(3.7 − 0.033s) − 2.25
0.825s = 42.625 + 0.1375s − 46.25 + 0.4125s − 2.25
−5.875
s=− = −21.36
0.275

Note that s∗ is below the borrowing constraint and thus the borrowing constraint can be ignored.
Now sub s∗ into (1) and (2) to get h∗1 and h∗2 :

h1 = h1 = 7.75 + 0.025s = 7.75 + 0.025 ∗ (−21.36) =⇒ h∗1 = 7.216

h2 = 3.7 − 0.033s = 3.7 − 0.033 ∗ (−21.36) =⇒ h∗2 = 4.405

b. (5 points) From part (a) (i.e., she can predict her injury), explain in two or three sentences
whether the individual will work more or less in period 2 if there is a borrowing constraint of $10.

Answer: She will work less as she can borrow less and so there is no point to work more in
period 2 to transfer consumption to period 1 (which is what she wants to do). One can also directly
see this from the FOC for h2 (remembering that s is negative).

c. (20 points) Suppose that instead that the individual was uninjured in period 1 and was

7
expected to remain uninjured in period 2. To her surprise, though, she gets injured in period
2 (e.g., injury was received by a brutal slash while playing hockey). How many hours does the
individual work in period 2 now?

Answer: Somewhat tricky question. Need to completely redo individual’s optimization to see
what she saves in period 1 when not injured (and thinks she won’t be injured next period, so cannot
take saving value from part (a)):

1 1 1 1
max ln(20h1 + 10 − s) + ln(16 − h1 ) + ln(25h2 + 10 + 1.1s) + ln(16 − h2 )
h1 ,h2 ,s 2 2 2 2

Take FOCs (and simplify each one down):

∂u 0.5 · 20 0.5
: =
∂h1 20h1 + 10 − s 16 − h1
=⇒ 160 − 10h1 = 10h1 + 5 − 0.5s
=⇒ h1 = 7.75 + 0.025s (1)
∂u 0.5 · 25 0.5
: =
∂h2 25h2 + 10 + 1.1s 16 − h2
=⇒ 200 − 12.5h2 = 12.5h2 + 5 + 0.55s
=⇒ h2 = 7.8 − 0.022s (2)
∂u 0.5 0.5 ∗ 1.1
: =
∂s 20h1 + 10 − s 25h2 + 10 + 1.1s
=⇒ 12.5h2 + 5 + 0.55s = 11h1 + 5.5 − 0.55s
=⇒ 1.1s = 11h1 − 12.5h2 + 0.5 (3)

Sub (1) and (2) into (3) to find s∗ :

1.1s = 11h1 − 12.5h2 + 0.5

=⇒ 1.1s = 11(7.75 + 0.025s) − 12.5(7.8 − 0.022s) + 0.5
1.1s = −11.75 + 0.55s
11.75
s∗ = − = −21.36
0.55

Now individual gets injured after saving in s∗ = −21.36 in period one. She has already done all
period 1 choices, so just need to set up (static) period 2 optimization setting s = −21.36:

1 3
max ln(25h2 − 40) + ln(16 − h2 )
h2 4 4

8
Take FOC and solve:

∂u 0.25 · 25 0.75
: =
∂h2 25h2 + 10 − 1.1 ∗ 21.36 16 − h2
=⇒ 100 − 6.25h2 = 18.75h2 − 10.12
110.12
=⇒ h∗2 = = 4.40
25

9
4. (25 points) In class, we talked about identifying intertemporal labour supply. The basid idea
behind the regressions that were run is that we wanted to see if individual’s worked more hours
when they saw a pay bump as our models would predict. Speficially, we were interested in running
the following regression:

hid = β0 + β1 wid + id

where hid is hours worked by individual i on a given day d and wid is the individual’s wage that
day.

a. (5 points) Give the main reason that much of this literature has focused on taxi drivers and
bike couriers to estimate the above regression.

Answer: Because these professions experience day-to-day wage variation which is quite rare (most
people earn say an hourly wage which does not vary day-to-day).

b. (5 points) Give one reason why if you ran the above regression on taxi drivers your estimate
of β1 might suffer from bias. Be clear on what two conditions must be satistified for you reason to
generate bias.

Answer: Plenty of possible reasons. My reason: more experienced drivers “know” the good days
and so are more likely to work on days with high wages. Futhermore, experienced drivers work
less hours as they are older and find it tought to do really long shifts. Thus my omitted variable
experience, denoted by Z, is correlated with both wages (corr(Z, w) 6= 0) and the outcome which
is hours worked (corr(Z, h) 6= 0).

c. (10 points) In order to get rid of the bias you found in part (b), some economists have used rain
as an instrumental variable to estimate the above regression. Discuss the validity of this instrument.

Answer: (i) the instrument is related to wages as rain increases the demand for taxis and thus
their wage. So the instrument is relevant (i.e., corr(Z, w) 6= 0).
(ii) Can answer either way here. One way: I think the instrument is likely valid as individuals
working in the rain should be similar to those working in the sun and the instrument is unlikely to
directly affect the number of hours a cab driver works.
Other way: I think the instrument is invalid as rain likely directly affects hours worked as taxi
drivers do not like driving in the rain (it is far more stressful!). [note: plenty of other of reasons
you could say it is invalid]

10