Problem Set 2.

Microeconomic foundations
a.grodecka@lse.ac.uk

Question 1

How do we know that M Pn = w (marginal product of labour equals wage) and that M RSl,c (marginal rate of substitution) equals (1 t)w? The rst result comes from the assumption about the form of our production function (Y = zN d ). When we dierentate this function w.r.t. N d , we will get z. dY =z (1) dN d How do we know that w = z in equilibrium? This result comes from the optimization problem of a rm, which wants to maximize its prot . = Y wN d = zN d wN d (2)

When we dierentiate this function with respect to N d we see that z = w, which gives us also the 0-prot condition in the equilibrium. Because z is a constant here, we will get a horizontal labor demand curve in this simple case.

M RSl,c = (1 t)w is derived from the optimization problem of a consumer. Consumer has some utility U that depends on his consumption c and leisure l (remember that l +N s = h). He also faces the budget constraint C = +(1t)wN s = +(1t)w(hl). How do we calculate M RSl,c ? M Ul M RSl,c = M Uc . We get the marginal utilities from the consumers optimization problem which can be solved by writing down a Lagrangian function: L(l, C) = U (l, C) + (C (1 t)w(h l)) , where denotes the Lagrangian multiplier. Now lets maximize this function w.r.t. c and l to get marginal utilities. w.r.t. c dU (l, C) +=0 dC w.r.t. l dU (l, C) + (1 t)w = 0 dl So M RSl,c =
M Ul M Uc

(3)

(4)

(5)

dU (l,C) dl dU (l,C) dC

(1t)w

= (1 t)w. (6)

Question 2

Does the hump-shaped form of the Laer curve imply that on the good side of the Laer curve the income eect dominates (and not the substitution eect, as we usually assume)? No, throughout the book and exercises we assume that the substitution eect is larger than the income eect, i.e. with a rise in real wage our labor supply will increase, so we face an upward-sloping labor supply curve. The income eect says that after an increase in income we will increase both our consumption and leisure which are assumed to be normal goods. Since leisure increases, the income eect would suggest a falling labor supply after a rise in wage. However, we assume that the substitution eect always prevails. That is, when the real wage increases, the leisure becomes more costly in relation to consumption, so we substitute from leisure to consumption. The substitution eect causes thus the leisure to fall and the labor supply increases. The two eects suggest opposite directions of the movement of labor supply. But because of our assumption that the substitution eects is larger than the income one, the labbor supply will always increase after an increase in real wage. Now if we are on the left, good side of the Laer curve, when the tax rate goes up, we will get more revenue from taxes. But it does not mean that our assumption about the upward-sloping labor supply curve does not hold any more! When the taxes are higher, we will supply less labor, because our real wage decreases. The reason for the rise in government revenue on the good side of the Laer curve is not the increase in the tax base w(h l) = wN , because the tax base will be lower exactly because of our assumption that the substitution eect is higher than the income eect. The reason for the rise is the mechanical eect of a rise in the tax rate t which constitutes another part of government revenue given by REV = tw(h l). When the positive eect of a rise in t outweights the decrease in tax base, we are on the good side of the Laer curve.