Borjas Labor Economics 5e OLC Student Discussion Question Answers. Dollars of Consumption $95 $ Hours of Leisure. Chapter 1

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1 Chapter 1 1. Labor economics is the study of the labor market where individuals supply their labor and firms demand labor. Labor economists study theoretical, empirical, and policy questions concerning the labor market such as unemployment, wages, the income distribution, labor migration, why some people pursue education, etc. 2. The key actors in the labor market are workers, firms, and governments. Typically, workers are assumed to maximize their utility (not their income), while firms are assumed to maximize their profit. The government s motives depend on the situation. 3. The most valuable models yield testable empirical predictions. If the predictions match the data then one can use the model to predict how market outcomes (such as employment, wages, education levels, etc.) will respond to policy changes or governmental interventions. 4. The model ignores several factors, including the cost of moving, the willingness of workers to live in Alaska or work in the cold, and the capital labor tradeoff faced by the firm. 5. Positive economics concerns what is, i.e., facts. Normative economics concerns what should be, i.e., judgments. Because people should agree on the facts but will make different judgments based on their own preferences and experiences, normative questions are more difficult to answer than are positive questions. Chapter 2 1. A. Dollars of Consumption $95 $ Hours of Leisure B. If Madison works 8 hours a day, she then consumes $15 + 5(8) = $55 each day and is able to leisure 16 8 = 8 hours each day. 1

2 2. A. Dollars of Consumption $700 $500 TREX Standard -$ Hours of Leisure B. Notice that the TREX labor-leisure constraint is above the standard constraint as long as hours of leisure is less than 16, i.e., as long as hours worked is greater than 4 hours per day. This can be solved from 37.5h 50 25h. C. Under TREX, the effective wage increases (as long as one works more than 4 hours a day). As the wage increases, leisure will decrease by the SE but increase due to the income effect. Thus, assuming that the SE dominates the IE, realtors under the TREX system will work more hours than under the standard system. Moreover, consider someone who would choose to work 4 hours under the standard system. This person will clearly work more hours under the TREX system as the income effect is secondary as one needs to work more than 4 hours to benefit from the TREX system. 3. A. Dollars of Consumption $162 $100 LA constraint $38 Eugene constraint $17 $ Hours of Leisure B. In Eugene, if Thomas leisures for 12.4 hours, he will have 4.6 hours in which to work. Thus, his consumption will be 5(4.6) + 15 = $38. Comparatively, if Thomas leisures for 12.4 hours in LA, he will only have 2.6 hours in which to work. Thus, his consumption would be 10(2.6) + 12 = $38. Further, as the indifference curve passing through (l = 12.4, c = $38) is tangent to the Eugene constraint, it cannot be tangent to the LA constraint. Moreover, the LA constraint must be above the indifference curve 2

3 to the left, i.e., the points corresponding to fewer hours of leisure in LA. (Note, this does not necessarily mean that the person works more hours in LA because of the 2 hours lost to the commute.) C. Non-labor income is greater in Eugene, which leads the worker to leisure more in Eugene than in LA. Further, the two hour commute time in LA provides the incentive to work many hours once the worker decides to work at all. 4. The increased costs of children predominantly are increased education costs, increased healthcare costs, increased child care costs, and an increase in the opportunity cost of not working if one parent decides to stay at home. Of these costs, the most important one is probably the increased costs of child care (both monetary and psychic if mothers feel guilt when they don t stay home with their children) and/or the increased opportunity cost of staying home with children as labor market options for women are better than they have ever been. The cost of providing stuff to children has likely fallen, especially essential stuff like food. Obviously the cost of providing some things like IPods and video games has increased. 5. A. Increasing benefits paid to EITC recipients will probably be more successful at alleviating poverty for several reasons. First, only about one in three minimum wage earners are the sole provider for their household (about one-third are high school students, and about one-third are people with spouses who earn considerably more so that their household isn t in poverty to begin with). Second, the EITC offers a transfer to the working poor by increasing their effective wage by as much as 40%. Thus, the money devoted to the EITC program truly targets poverty. B. The EITC is a very costly program, whereas the minimum wage costs the government nothing. Chapter 3 1. A. E q(e) R(q) MP E VMP E Wage TC(q) Profit 0 0 $ $8 $0 $ $76 19 $76 $8 $8 $ $ $68 $8 $16 $ $ $60 $8 $24 $ $ $52 $8 $32 $ $ $44 $8 $40 $ $336 9 $36 $8 $48 $ $364 7 $28 $8 $56 $ $384 5 $20 $8 $64 $ $396 3 $12 $8 $72 $ $400 1 $4 $8 $80 $320 B. Maximum profit occurs at q = 9 child hours of day care per day. But this can also be seen as VMP E is greater than the wage for all q less than or equal to 9; whereas the wage exceeds the VMP E when q = 10. 3

4 C. Labor demand = marginal revenue * MP E, which, in this case, as the price is constant at $4 per hour of child care, yields Labor Demand = p * MP E, = 4 * (20 2E) = 80 8E. Wage $80 10 Hours of Labor Demanded 2. When the wage increases in the long run, the firm will substitute labor with capital (the substitution effect) and the firm will choose to produce less output as the cost of production has increased and thus to employ less labor (the scale effect). Both of these effects imply that the demand for labor is downward sloping. In the short run, the substitution effect does not exist (as the firm cannot use more capital), but the scale effect remains. And thus, assuming that the marginal product of labor is decreasing, demand for labor will be downward sloping in the short run as well. Wage $95 $55 L D SR more substitutable L D SR less substitutable L D LR more substitutable L D LR less substitutable Hours of Labor Demanded Labor demand is more inelastic in the short run than in the long run in general, because the firm can take full advantage of the economic opportunities introduced by a change in the wage only in the long run. This makes the long-run labor demand curves flatter. In both the short and long runs, however, demand for labor will be more elastic when labor and capital are more substitutable, which makes both more substitutable curves flatter than their corresponding less substitutable curves. 4

5 3. The text lists a few problems. The data were survey data, which is not as reliable as payroll data. Card and Krueger s survey data seem to have a lot of measurement error. The actual employment effect also might be really small, which would make estimating it very difficult and susceptible to things like measurement error. Concentrating on a single industry, especially one with limited technology, may also be problematic. Finally, the issue of timing is important when was the law announced, when do firms make decisions, and when was the data collected? If the change was announced (and firms had the ability to react to the announcement) prior to the pre-effect data were collected, then the data do not contain information on the employment effect stemming from the legislation. Another criticism of the study includes Card and Krueger s measure of employment each fulltime person plus one-half for each part-time worker. This calculation is suspect in an industry dominated by teenage employment when management may react to higher wages by cutting everyone s hours a little bit rather than by laying off workers. 4. When the firm agrees to pay more of a (fixed) benefit in exchange for a lower wage, the firm will find it optimal to hire fewer workers and employ each for more hours as the firm will be able to pay a lower wage while only needing to pay the fixed retirement benefit of $250 per month once for each worker. Employment Hours Worked 5. Given I-Tech s production function of Q = f(e) = 100E, its marginal product of labor curve is MP E = 100. Further, given its demand curve of Q = p, I-Tech faces an inverse demand curve of p = Q. From here, its marginal revenue from selling output is MR = Q = E = E. Finally, I-Tech s labor demand curve, which equals VMP E is VMP E = MP E MR = 100 (600 10E) = 60,000 1,000E. Chapter 4 1. The wage differential of $3,000 is not likely to last in the long-run as other students will also pursue math education in the face of the differential. Thus, in the long run, there may be a premium for math teachers, but it is not likely to be as large as the initial premium. Education majors, therefore, should base their subject decisions on a lower (but unknown) differential. This is the main result for a basic cobweb model. 2. Suppose that if a particular labor market was competitive, the equilibrium wage would be W PC and the level of employment would be E PC. If the market is controlled by a monopsonist, the wage would be W MON and the level of employment would be E MON, where W PC > W MON and E PC > E MON. Now, if the government imposes a minimum wage on the monopsonist, the monopsonist faces a new marginal cost of labor curve, and chooses a level of output where the new (flat) marginal cost of labor curve intersects the demand for labor. If the minimum wage, therefore, is above the competitive wage (w PC ) but below the marginal revenue product of labor at the 5

6 monopsony level of employment (E MON ), then the minimum wage will result in the monopsonist hiring more workers (though fewer than under perfect competition) and paying a wage higher than the perfectly competitive wage. Wage Rate Marginal Cost of Labor Labor Supply W MIN W PC W MON Labor Demand E MON E PC Labor E MIN 3. In this case, firms will pay blacks less than whites. Under general assumptions about the populations of the two types of labor being relatively similar, firms will also hire more whites than blacks. The reason firms willingly pay different wages is that the firm makes its decisions on the margin. Notice that the firm faces a higher marginal cost of hiring a black worker (as the marginal cost of doing this is upward sloping) than hiring a white worker (for whom the wage, and therefore the marginal cost of hiring, is constant). Dual Labor Markets: One Competitive, One Non-Competitive Wage Rate Marginal Cost of Black Labor Black Labor Supply W W W B Labor Demand White Labor Supply equals White Marginal Cost of Labor E B E W Labor 6

7 4. The graph below shows how the labor market outcome changes pre- and post Notice that post-1933, the number of unemployed equals E E MIN. Wage Rate Labor Market Outcomes: Pre 1933 = Monopsony Post 1933 = Minimum Wage Regulation Marginal Cost of Labor Labor Supply Wage Post 1933 = W MIN W PC Wage Pre 1933 = W MON Labor Demand E MON E PC E Labor E MIN 5. A. To solve for the optimal number of workers, set MC = VMP E : 200E = E 1200E = E* = 40. So SBU hires 40 workers. B. Using the answer to (A), 40 = 0.01w 120 yields w* = $16,000. C. Q = 100E = 100(40) = 4,000 units of output. D. Using the demand curve: 4000 = p yields p* = $400. E. Profit = pq we = $ $ = $960,000. 7

8 Chapter 5 1. Firms face a tradeoff. They can offer risky jobs at a wage premium or they can undertake the costs of making their jobs safer, thereby saving the wage premium. Likewise, workers face a tradeoff in their utility between working risky jobs (which they don t like) and receiving a wage premium (which they do like). In the end, the firms with the lowest costs of creating a safe environment will do so and hire the workers who are least willing to work in risky jobs. Other firms will offer risky jobs and employ the workers who are most willing to work in risky jobs. The equilibrium is described by the hedonic wage function. 2. When a firm ban s smoking, the firm might need to offer a wage premium to attract workers. (Then again, it might not have to.) Let D be the additional wage cost of the firm when it bans smoking. Again, recall that D $0, and in particular D = $0 is not unreasonable. Similarly, let B be the amount saved per worker on health insurance premiums when smoking is banned. Again, by assumption, B $0. The firm, then, will voluntarily ban smoking in the workplace if B D. Thus, as the firm will voluntarily ban smoking whenever B D, if the government intervenes and forces firms to ban smoking, then it must be that B < D and the intervention hurts firms. (It should be noted, however, that it might be that D depends on how many firms ban smoking. If only a handful of firms ban smoking, then D might be small or even $0, but eventually D increases and other firms do not ban smoking. If all firms are then required to ban smoking, D may return to $0 for every firm as workers have no alternatives other than to not work.) 3. There are two cases to consider. Case One. Suppose state law requires all public employees to save 6.5% of income in a retirement account. This can be paid either by the employee or by the employer. In this case, who pays the 6.5% retirement benefit is a straight tradeoff with the wage. If the employer pays, then the workers should earn 6.5% less than they otherwise would. Likewise, when the legislature now requires workers to pay the 6.5% into retirement themselves, their wages should be increased by 6.5%. Put differently, if the 6.5% burden is shifted from the employer to the employees, then the government employees are correct in saying that their wages should be raised by 6.5%. Case Two. Suppose the union has negotiated that the government pays 6.5% into retirement accounts for its employees. The legislature then changes the law so that the government will stop doing this in effect, requiring employees to pay their own retirement benefits in whatever amount they choose. In this case, retirement benefits are left to the employees so that many employees will likely choose to save less than 6.5% of their earnings to their retirement. Thus, to make these employees equally happy under both regimes, their wage must increase when the state stops providing retirement benefits but not by the full 6.5%. As an arbitrator, one might be tempted to rule that wages should increase by the full 6.5%, as it would be difficult to know what the average saving rate will be after the rules change. The arbitrator could also look at private sector employees who are in charge of their own retirement savings to estimate the average saving rate. If this is less than 6.5%, the arbitrator might rule that wages should increase by this lower rate. 8

9 4. As people prefer working in Atlanta, the solution will have w A < w B, so let represent the wage differential between the two locations as = w B w A. Given any differential,, we know that E B = ( /5) = Thus, we now have five equations and five unknowns: w A = E A. w B = E B. = w B w A. E B = E A + E B = Solving the system is straightforward and results in w A = $8, w B = $12, = 4, E A = 5000, and E B = There is a $2,000 differential between the two salaries. In addition to this, we need to calculate the probability of death per mile (or per 180 million miles). Suppose both companies drive 180 million miles each year. This requires 180 million divided by 240,000 miles per driver, which equals 750 drivers. Thus, over the year, U.S. Trucking is expected to have 180 / 12 = 15 fatalities per year. In contrast, American Trucking is expected to have 180 / 15 = 12 fatalities per year. Finally, the U.S. Trucking drivers earn $2,000 x 750 = $1,500,000 more than the American Trucking drivers. This additional income, however, comes at a cost of having three more fatalities per year on average. Thus, the value of each life is $500,000. Chapter 6 1. A. Tuition and books and the varying salaries need to enter the calculation. The cost of room and board should not as one needs to pay room and board whether or not one is in school. PV school B (1.1) 60000(1.1) (1.05) (1.05) (1.05) (1.05) (1.05) 35 2 $4,484,901 PV no school (1.07) 45000(1.07) 45000(1.07) (1.05) (1.05) 39 $2,662,672 Thus, as PV school = $4,484,901 while PV no_school = $2,662,672, one should choose to attend graduate school if basing decisions solely on present value of earnings. C. Other considerations, however, should enter the decision, such as how happy one would be in graduate school or how happy one would be as a manager vs. a professor. 2. This is true if revealing one s education never factors into selling one s product. If, however, revealing one s education factors into selling one s product, then it is false. For example, someone can become a self-employed financial planner with no schooling. If this person can sell her services without revealing that she has no education, then she would not receive education. However, if in order to sell financial services one needs to signal that one knows what they are doing, then the person will obtain education. Simply put, it depends on whether the signal is a signal to just employers or is a signal to buyers (customers) as well as employers. 9

10 3. Notation: α = 1/3, 1 α = 2/3, MP H = 3, MP L = 2, and price = $1 where α is the proportion of high types. A. Expected value of marginal product equals α VMP H + (1 α) VMP L = α MP H MR + (1 α) MP L MR = (1/3)(3)(1) + (2/3)(2)(1) = $2.33. B. If education is a pure signal, then it has no effect on marginal product. C. The requirements are that smart people must want to purchase the signal while dumb people do not want to purchase the signal. That is: Smart types: 3 y/3 2 => 3 y. Dumb types: 2 3 y/2 => y 2. Thus, as long as 2 < y < 3, there will be a signaling equilibrium. 4. There are two differences between the people living in equatorial and non-equatorial countries: the people in equatorial countries value the present more highly and they face a higher rate of interest. It is important to note that the higher interest rate simply reinforces their presentmindedness. That is, when the interest rate is high, people value the present relatively more than the future. Thus, overall, equatorial peoples value the present more so than non-equatorial peoples. This causes equatorial people to make fewer investments in education. If education is a key to economic growth, then this present-mindedness provides an explanation as to why equatorial countries have experienced less economic growth than their more northerly or southerly counterparts. 5. Suppose job-tenure is important to the computer industry. Then computer firms may pay a wage below the marginal product at low levels of tenure in exchange for wages above the marginal wage at high levels of tenure. Taken on the whole, the computer industry could very well be paying the competitive wage. Empirically, this could be further explained by considering wages and productivity of workers at all tenure (experience) levels. Dollars Wage Tenure Profile Value of Marginal Product Years on the Job 10

11 Chapter 7 1. Consider the two views. Rate of Interest High Income Families Egalitarian View Return to Human Capital Middle Income Families Low Income Families Human Capital Elitist View Rate of Interest Return to Human Capital: Low Ability Families Return to Human Capital: Middle Ability Families Return to Human Capital: High Ability Families All Income Families Human Capital Notice that under both views, low income families will acquire less human capital than the high income families. Distribution of Earnings under Both Views Wage Wage Education Profile Human Capital 11

12 2. Some people have argued that there is empirical evidence of human capital externalities. Specifically, some researchers have found that social capital determines in part one s human capital investments. Thus, by dating someone who is less likely to obtain human capital, you may become more likely to also obtain less human capital. Of course, the person you are dating would become more likely to obtain more human capital. Although this relationship probably exists, it does not mean it is a causal relationship. One might choose to date someone with fewer human capital options/desires because they themselves have fewer such desires. 3. The vote may be close because of national pride, but on the whole, the group that wins is likely the best. And although all or most of the groups are very good, the best is exceptionally good, and will be able to command economic rents. The ability to earn rents justifies the recording contract. 4. First, (B) is easy as the wage gap is 0 as the 90 th percentile person and the 10 th percentile person both earn $20,000. The Gini coefficient is a bit harder to calculate. Notice that there is 1000 $20,000 + $20,000,000 = $40 million of income in the economy. Taking the first 200 workers to be 20% of the population, they account for 200 $20,000 $40 million = 10% of all income. Likewise, the first 400 workers account for 20% of all income. And so on to the point where the first 1000 workers account for 50% of all income. The area between the perfect-equality Lorenz curve and the actual Lorenz curve, therefore, is (1/2) (1-0.5) 1 = Doubling this gives a Gini coefficient of The Gini coefficient in question 4 is not closer to 1 because the 1000 poor people are not dirt poor (receiving $0 or close to $0). If X is the amount of income of the poorest 1000 people where X is between 0 and $20 million, then the income share of all 1000 people, which is the Gini coefficient in an example like this, is 1 [1000X (1000X+20 million)] = 1 [ X (X+20,000)]. Notice when X = $20,000, this formula yields a Gini coefficient of 0.5. Moreover, if X = $0, then the Gini coefficient is 1 and when X = $20 million, the Gini coefficient is essentially 0. Chapter 8 1. Wages are more compact (and predetermined) in the government sector. In the private sector, however, wages are determined more by skills. Thus, as government wages are less disperse, it will attract the low-skill workers while the private sector will attract the high-skill workers. Wage Distribution of Skills and Wages Private Sector Wages Government Wages Select Government Job Max Gov t Skills Select Private Sector Job Skills 12

13 2. A. With no migration costs, workers migrate if and only if w A < w SD : s < s which is a true statement for all skill levels. Thus, all Adanacs will migrate so that the average number of efficiency units of immigrants is 50, and the immigrant flow is neither positively nor negatively selected as everyone migrates. B. If it costs $50 to migrate, then the condition for migration is: s < s 50 which is never true for any skill level. Thus, no Adanacs migrate. C. If migration costs are not constant in the population, then it will be the case that the skill group with the lowest costs (below $30 in this example) will migrate as in part A while the skill group with the highest costs (above $30 in this example) will not migrate as in part B. Thus, as in the question, if migration costs are lower for the most skilled workers, then the average skill level of the migrants will be above 50 and the immigrant flow will be positively selected. 3. The statement is true. Positively sloped native labor and immigration supply curves are represented below. Notice that because the wage falls due to immigration, there are jobs that are held by immigrants that used to be held by natives. However, natives are not willing to work these jobs at the new lower wages. Domestic Labor Market with Immigration Wage Domestic Labor Supply Labor Supply with Immigration W no immigration W immigration Domestic Labor Demand E no imm E imm Total Domestic Employment 4. Currently in the United States, most people receive health insurance through their employer. Thus, if a worker quits her job, she will lose her health insurance until she finds another job that offers the benefit or until she purchases it herself. This is a substantial cost of switching jobs. Thus, an employer-based health insurance system keeps labor mobility artificially low as some workers are not willing to risk losing their health insurance. A single-payer, federally funded health care insurance system, therefore, would increase labor mobility and labor market efficiency. 13

14 5. Returning to Miami is called return migration. Moving a second time from Chicago onto a new location (Minneapolis) is called repeat migration. For the return migration family, it might have learned that its wage outcome in Chicago is not as great as thought when originally deciding to move to Chicago. (For example, the household might not have realized that there is no state income tax in Florida while there is an income tax in Illinois.) Alternatively, this family may have learned that it doesn t like cold weather climates. For the repeat migration family, it might have learned that moving costs are low for them (they have no kids or that their kids adjust well to new schools). This household might also have intended all along to have move to Chicago to advance a career and then to move on to somewhere else to advance a career again. Chapter 9 1. The statement is false. It may be that the North and South have the same distribution of discriminating firms. Yet, if there are more blacks in the South than in the North, then the discriminating firms in the North may be able to hire all whites without paying a premium, while the discriminating firms in the South will have to pay a premium. Thus, empirical estimates will show that the discrimination coefficient is higher in the South than in the North simply because there are more of the population discriminated against in the South. 2. A. The most likely explanation for the difference in payouts is customer discrimination. That is, there is more demand to see Yan tournaments than to see Yin tournaments. B. This is called customer discrimination. C. Given the facts, it would seem that the differential is likely to persist over time. 3. A. If employers have a taste for discrimination, they will find it beneficial to pay the costs of moving the firm to the white suburbs in order to hire more white workers. B. If customers have a taste for discrimination, the firm will find it beneficial to pay the costs of moving the firm to the suburbs in order to hire more white workers if doing so allows it to sell its product at a higher price because its customers are willing to pay more for the good when the firm employs more whites. C. Empirically, one could distinguish between these two explanations by looking at what types of firms have moved based on where/how they sell their output. If the firms that have moved are manufacturing firms that sell their output throughout the region, then the explanation would more likely be employer discrimination. However, if the firms that have moved are retail firms hiring workers that interact with customers, then the explanation would more likely be customer discrimination. 14

15 4. Wage Education Profiles: Wage White Profile $7.904 $7.708 $6.22 Differential due to Skill Differences Differential due to Discrimination Black Profile $6 $ Years of Schooling A. The raw wage differential for the average black and average white worker is $ $6.22 = $ B. The Oaxaca decomposition is calculated as: W = (6 5) + ( ) * (12.2) + (0.14)*( ) = = Thus, the portion of the wage differential attributable to skill differences between white and black workers is while the portion due to labor market discrimination is The firm must hire 200 workers. First, if the wage ratio, w W / w B, is less than 1, then white workers are cheaper than black workers, and the firm, which discriminates against black workers, will hire 200 white workers and no black workers. So, for the remainder of the problem, assume that the wage ratio is greater than 1. As the wage ratio is greater than 1, the firm will hire some black workers. And, in fact, it will hire black workers up to the point where the marginal cost of hiring a black worker, (1+d)w B equals the marginal cost of hiring a white worker, w W. As d = 0.01E B, this means that And therefore, MC B = MC W (1+0.01EB) w B = w W. ww ww E B or 0.01EB 1. wb w B 15

16 Graphically, the firm s demand for black workers is: Wage Ratio ( w W / w B ) Number of Black Workers (E B ) 200 Notice that under this model, the firm is completely segregated only if the wage ratio is too low (below 1) or too high (above 3, i.e., w W /w B =3 when E B = 200 in the earlier equation). Anywhere in between, the firm hires a portion of black workers and a portion of white workers. Chapter Unions are better off the more inelastic is the demand for union labor. This can be achieved by increasing consumer demand for union products. (It could also be achieved by increasing the firm s difficulty to switch between union labor and non-union labor or capital.) In this example, the union is hoping to entice consumers to be unwilling to purchase foreign-made goods. This would presumably increase the demand for union-made goods (especially if unions are prevalent in U.S. manufacturing), which in turn increases the value of union labor. If successful, the union would then expect to successfully negotiate higher wages for its members as the firm s option of moving its factories over seas becomes less valuable. 2. Recall that the union wage (and possibly the level of union employment) will fall the more elastic is the firm s demand for union labor. Now consider Marshall s four rules and their relation to the automobile industry over the last three decades. Labor demand is more elastic the greater is the elasticity of substitution between labor and capital or non-union labor. Automation (robotic production) has become more prevalent. This has increased the elasticity of substitution between labor and capital. Likewise, the industry has started to engage in outsourcing, which is essentially a means of being able to more freely use non-union labor. Labor demand is more elastic the greater is the elasticity of demand for the output. Over the last 30 years, the automobile industry has become more competitive as import restrictions have been lifted and many more foreign firms have come into existence. Greater competition is associated with greater elasticity of demand of output. Labor demand is more elastic the greater is labor s share in total costs. Whether labor s share in the production of automobiles has increased or decreased is not common knowledge. Large automobile makers like GM and Ford have made claims recently 16

17 that the most expensive part of any car made is the healthcare and retirement costs of workers. (Such statements, of course, really mean that the healthcare and retirement costs the firm pays to its retirees, not current workers. Nonetheless, firms like GM and Ford consider such costs as important labor costs as their current workers will, one day, be its retirees.) Labor demand is more elastic the greater the elasticity of supply of other factors of production, such as capital. Over the last 30 years, the automobile industry has become more competitive as import restrictions have been lifted and many more (foreign) firms have come into existence. As foreign workers, more or less, are non-union, this has caused the supply of non-union labor to become more elastic. Overall, each of the rules has moved against the UAW s desires, and might suggest why union membership has decreased over the last 30 years. 3. A. The union wage gap overstates the union wage gain, because unions tend to hire the most productive workers and because union workers must return some of their gains to the union in terms of union dues. B. The union wage gap understates the union wage gain because of the spillover effect. Specifically, non-union firms may pay a higher wage in order to prevent a union from forming. C. High-wage workers in a non-union firm would likely not support the formation of a union, because a union will likely dictate that all workers be paid according to an observable characteristic such as tenure and not based on productivity. To the contrary, low-wage workers in a non-union firm are likely to support the formation of a union, because they will be paid according to their observable characteristic (i.e., tenure) and not on their actual productivity. 4. The data cannot help reveal which effect is more important. Over the last 40 years, participation in private sector unions has fallen significantly. Thus, the remaining unions should be able to hire even better workers (the elite of the elite), which would predict that the estimated union wage gain should be higher now than 40 years ago. At the same time, as union coverage falls, the spillover effect is also reduced as unions have lost their threat of organizing. Thus, wages in nonunion firms should fall relative to union wages, and therefore the estimated union wage effect should again be higher now than 40 years ago. 5. In this situation, the firm will begin by offering a low wage, and slowly increasing it with time. For example, it might offer a starting salary of $30,000 but after a two week strike increase its offer to $32,000. Thus, its wage offers goes up with time. The literature refers to this as the firm s concession path, which is upward sloping (unlike the union s resistance curve which is downward sloping). 17

18 Chapter The production function is such that Q = w E, and the firm hires 100 workers. A. MP W = E = 100. B. AP W = w E / w = E = 100. C. The efficiency wage solves MP W * (1/AP W ) = 1, which is true for all wage levels. So the efficiency wage can be any positive wage. D. Likewise, all levels of output insure that the elasticity of the wage equals 1. E. In this example, the employment level does not affect the equilibrium. 2. A. The rationale for the proposed system is to make sure all workers (students) accomplish the same work if they are to be rewarded (pass the test). Thus, the proposed system resembles a piece rate compensation scheme. B. The more able students would opt for the new scheme as they could earn their high school degree much faster than they are currently able. C. The benefit to the new education proposal is that it allows the most able students to complete high school quickly and then move on to college. The cost is that the least able students may find it optimal to never finish high school, and in fact, if they believe they will be unlikely to finish high school they will be likely to drop out of the education system as soon as legally possible. D. If test scores are measured on an absolute basis, then the system will resemble a tournament in that only a select few (i.e., 10%) of students will move on to the next level after any given test. In this case, it is not enough to learn the material, but one must learn the material better than 90% of one s peers. E. In addition to the benefits and costs listed in part C, a tournament may elicit even more learning by everyone involved as the students know they are competing against each other. On the other hand, the students who feel they have no hope of being in the top 10% may not put forth any effort at all. 3. Whenever a firm hires different employees to do different jobs, it may be the case that the observable productivity of one type of employee differs from the observable productivity of the other. In this case, the productivity of the quarterback may be easily observed in terms of pass completions, touch downs, interceptions, etc., but the productivity of an offensive lineman is less clear as the offensive line works together. Thus, management will find it best to condition the quarterback s pay on the observable characteristics of productivity while conditioning the offensive lineman s pay on the less direct, yet observable characteristics, that are correlated with performance. 4. This is a tournament scheme. An orchestra may choose this scheme to try to elicit great competition among its top performers. It may also be the case that the orchestra really depends on just the one or two best performers for any instrument. Thus, paying greatly for first chairs is reasonable as they will be asked to carry the orchestra. Moreover, a tournament scheme will be preferred to a piece rate scheme (as it is difficult to know which performers are playing the best) or a time rate scheme as this fails to encourage perfection among any of the performers. 18

19 5. A. The upfront fee is an access or leasing fee that the worker must pay to be able to take advantage of the piece-rate (commission) system. B. It is likely that the most able realtors will choose the TREX firm, while the least able workers will continue with the standard firms. This is because the most skilled realtors will be able to keep more of the profits generated by their labor, while the low skilled realtors will stay with the standard firms in order to reap the average reward. C. Despite the explanation in (B), both types of firms will continue to exist. However, the time rate paid at the standard firm will fall as the most skilled workers opt for the TREX firm. Chapter A. The graphs of the marginal revenue and marginal cost of search are: Dollars $100 $60 Marginal Cost of Search Marginal Cost of Search in (E) and (F) $20 $10 Marginal Revenue of Search $10 $20 $25 Wage Offer B. According to the MC and MR of search, it appears that the minimum wage offer is $0 while the maximum wage offer is $25. C. At a wage offer of $10, the marginal benefit of additional search is $60, while the marginal cost of search is just $10. Thus, the worker will continue to search. D. The worker s asking wage is $20, which solves MR = MC. E. If there are unemployment benefits of $200 a week, which equals $5 per hour, the new marginal cost of search is MC = w 5. (The new MC of search is parallel to the original MC of search but with an intercept of -5.) F. Using the new marginal cost, and solving MC = MR reveals that the new asking wage is $ When a potential worker has access to a good-old boy network with which to rely on for more wage offers, that worker s marginal revenue of continued search increases. That is, the value of rejecting an offer is higher as he or she expects another offer soon. Thus, access to networking will cause someone to increase their reservation (or asking) wage. People with access to networks 19

20 will, therefore, in the long-run, receive higher average wages than people without access to such networks. 3. A. The short-run Phillips curve suggests that when the FED changes interest rates to combat inflation, short-run unemployment will result. It is likely that such a policy will hurt less-skilled workers more than high-skilled workers as low-skilled workers experience more labor market turnover, and therefore may be more likely to find themselves in a spell of unemployment when the FED policy reduces the opportunity to find a new job in the short run. B. In the long run, however, the natural rate of unemployment is fixed. Thus, the FED policy should not affect workers adversely in the long run. This omits the possibility that the FED s short-run policy prescriptions might affect the natural rate of unemployment. It is quite possible, however, that an aggressive policy of controlling inflation in the short run is a positive feature of an economy, thus allowing for a lower natural rate of unemployment in the long run. If this is the case, then all workers are helped in the long run by the FED s policy, even though it may have harmful short-run effects. 4. If all job openings are advertised on the web and all workers can access that listing of openings: A. Frictional unemployment will likely be reduced, as the web will reduce the time it takes for firms and workers to find each other. B. Structural unemployment will be left unchanged as the web does not retrain the unemployed. C. The level and amount of search overall will likely increase as the costs of search have been greatly reduced. However, because finding good matches is now quicker, the amount of workers searching at any point in time may actually fall. That is, more people search more often, but for shorter periods of time. D. Like in part (C), it is likely that the incidence of unemployment (i.e., search) will increase, but the duration of unemployment (the duration of search) will be shorter. E. The natural rate of unemployment should fall slightly because of the improvement on frictional unemployment. 5. A social safety net program that offers more unemployment benefits (either more dollars or for a longer period of time) will likely: A. Result in workers becoming unemployed more often as the pain of being unemployed is less. Of course, most unemployment benefits are paid out only if the person did not voluntarily quit, so employees may think of more creative ways to get fired. B. Result in longer periods of unemployment duration. This is certainly true if the benefit level is held fixed while the time one can receive benefits is extended. If the unemployment benefit is increased but not extended, one would still expect duration to increase as recipients of the benefit are more willing to risk being unemployed past the termination of benefits. C. Result in a higher accepted wage upon exiting unemployment. A primary benefit of unemployment insurance is not just to provide assistance during unemployment but to give the unemployed an opportunity to take a job that matches their skills (i.e., a high paying job) rather than to just accept the first (low-wage) job that comes their way. 20