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CHAPTER 3

3-1. Consider two workers with identical preferences, Phil and Bill. Both workers have the same life cycle wage path in other words, they face the same wage at every age, and they know what their future wages will be. Leisure and consumption are both normal goods. (a) Compare the life cycle path of hours of work between the two workers if Bill receives a one-time, unexpected inheritance at the age of 35.

Because the workers have the same life cycle wage path and the same preferences, they will have the same life cycle path of hours of work up to the unexpected event. An inheritance provides an income effect for Bill, and thus, he will work fewer hours (or at least not more hours) than Phil from the age of 35 forward.
Hours Worked

Life Cycle Path of Hours Worked


After Age 35: Phil Bill

Before Age 35: Bill and Phil

35

Age

(b) Compare the life cycle path of hours of work between the two workers if Bill had always known he would receive (and, in fact, does receive) a one-time inheritance at the age of 35.

In this case, because the inheritance is fully anticipated, and because it offers the same income effect with no substitution effect, Bill will work fewer hours (or at least not more hours) than Phil over their entire work lives.
Hours Worked

Life Cycle Path of Hours Worked

Phil

Bill

35

Age

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3-2. Under current law, most Social Security recipients do not pay federal or state income taxes on their Social Security benefits. Suppose the government proposes to tax these benefits at the same rate as other types of income. What is the impact of the proposed tax on the optimal retirement age?

Suppose social security benefits are the only pension benefits available to a retiree. The tax, therefore, can be interpreted as a cut in pension benefits. The cut in pension benefits shifts the budget line from FH to FE in the figure below, shifting the worker from point P to point R. (Note that FE and FH are both downward sloping, indicating that total retirement consumption is greater the later in life one retires.) This shift generates both income and substitution effects. Both of these effects, however, work in the same direction. First, the tax reduces the retirees wealth, reducing her demand for leisure, and leading her to retire later. At the same time, the tax reduces the wage that retirees receive when retired, effectively increasing (in relative terms) the wage they earn while working and generating a substitution effect that leads to more work hours, thus further delaying retirement. A tax on pension benefits, therefore, will delay retirement.
Consumption During Retirement F

U1

P U0 H

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Years of Retirement

3-3. A worker plans to retire at the age of 65, at which time he will start collecting his retirement benefits. There is a sudden change in inflation forecasting: inflation is now predicted to be higher than it had been expected. Put differently, the average price level of market goods and wages is now expected to increase. What effect does this announcement have on the persons preferred retirement age: (a) if retirement benefits are fully adjusted for inflation?

There will be no effect on the persons retirement decision if retirement benefits are fully adjusted for inflation as nothing changes in the persons calculations in real terms: the relative magnitudes of prices, wages and retirement benefits are the same with or without inflation. The person faces the same choice, so his decision does not change.

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(b) if retirement benefits are not fully adjusted for inflation?

If retirement benefits are not adjusted for inflation, the purchasing power of retirement benefits falls. If the person does not retire, he can enjoy the same consumption as he would without inflation as wages are assumed to fully adjust for inflation. If he retires at 65, his benefits are worth less in real terms (they can buy him less consumption) with inflation than without, so he cannot afford the same consumption path as before. Hence, his choice set over the years of retirement and consumption lies below the original (preinflation) choice set except at one pointwhere he does not retire at all. Thus, as long as leisure (i.e., years of retirement) and consumption are normal goods, the income and substitution effects both lead to the individual retiring later in life.
3-4. A 60 year-old worker has two choices. He can work five more years, earning $50,000 per year and then retire at age 65 and collect $12,000 in retirement benefits each year for the next 15 years; or he can retire at age 60 and collect $X in retirement benefits each year for the next 20 years. (Assume throughout the problem that a dollar received today has the same value as a dollar received at any time in the future.) (a) What value of X gives the worker the same total income in the two options?

Value of Option One = $50,000(5) + $12,000(15) = $430,000. Value of Option Two = 20X. Thus, the value of X that equates the two option values is $21,500.
(b) What value of X gives the workers the same total retirement benefits between the two options?

Value of Retirement Benefits under Option One = $12,000(15) = $180,000. Value of Retirement Benefits under Option Two = 20X. Thus, the value of X that equates the value of retirement benefits is $9,000.
(c) Suppose anyone aged 65 or older receives state-provided medical insurance for free. The worker also has access to the same medical plan for free as long as he continues to work. If he is under 65 years old and does not work, however, he can purchase similar health insurance for $6,000 each year. If he values retiring at age 60 over age 65 at $200,000, for what values of X should he retire at age 60?

Value of retiring at age 60 = 20X + 200,000 $6,000(5) = 20X + $170,000. Value of retiring at age 65 = $430,000. Thus, the values of X that makes early retirement the right choice satisfies: 20X + 170,000 > 430,000, which requires X > $13,000.

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3-5. Prior to the repeal of the Social Security earnings test, various changes were being considered in the program. Examine the following two proposals and determine if the changes lead to retirees working more hours: (a) Increasing the amount of exempt labor earnings from $17,000 to $25,000.

Increasing the amount of exempt labor earnings would shift the budget line from HGFE to HGFE in the figure below. Depending on the position of the workers indifference curves, it is evident that there are several possibilities. Worker 1 would still be unaffected by the earnings test. Worker 2, if affected, however, would only be affected by income effects if he is shifted to the segment HG, or by both income and substitution effects if he is shifted to the segment GF. Worker 3 also faces income and substitution effects, and the net result is ambiguous.
Consumption ($)

H H G F
Worker 2

G
Worker 3

F E

Worker 1

Hours of Leisure

(b) Increasing the implicit tax rate from 33 percent to 50 percent.

Increasing the implicit tax rate from 33 to 50 percent leads to a shift in the budget line from HGFE to HGFE in the figure below. Worker 1 would be unaffected by the earnings tax. Worker 2 would likely experience an income effect, where the tax increase moves him to segment HG and encourages him to consume less leisure (and work more hours). Worker 3 experiences both a substitution and income effect, the net effect of which is ambiguous.

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Consumption ($)

H H
Worker 2

G G

Worker 3

Worker 1

Hours of Leisure

3-6. Presently, there is a minimum and maximum social security benefit paid to retirees. Between these two bounds, a retirees benefit level depends on how much he contributed to the system over his work life. Suppose Social Security was changed so that everyone aged 65 or older was paid $12,000 per year regardless of how much they earned over their working life or whether they continued to work after the age of 65. How would this likely affect hours worked of retirees?

Labor force participation is likely greatest for those retirees whose social security income is low (below $12,000 per year). Thus, the change in benefits offers these retirees a pure (positive) income effect. These retirees should reduce their hours worked if not leave the labor force all together after the age of 65. In contrast, the policy change offers all retirees who would have earned more than $12,000 per month a pure (negative) income effect. These retirees will become more likely to work, or, if already working, more likely to work more hours after the age of 65.
3-7. Social Security is the largest government sponsored transfer program in the United States. It is comprised primarily of three programs old-age (retirement) benefits, disability benefits, and survivors benefits. Using Table 520 of the 2002 U.S. Statistical Abstract, create a table that reports for 1990, 1995, and 2000 the total number of people receiving benefits in each of these three programs, the total benefits paid by the programs, and the average monthly benefit received per person for each program.

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The data from Table 520 of the 2002 U.S. Statistical Abstract follow: 1990
Old-age Benefits Number of Beneficiaries Total Annual Expenditures Avg Monthly Exp. per Beneficiary Disability Benefits Number of Beneficiaries Total Annual Expenditures Avg Monthly Exp. per Beneficiary Survivors Benefits Number of Beneficiaries Total Annual Expenditures Avg Monthly Exp. per Beneficiary

1995 30.139m $224.381b $720 5.862m $40.898b $682 7.379m $67.302b $680

2000 31.761m $274.645b $845 6.675m $54.938b $787 6.981m $77.848b $810

28.369m $172.042b $603 4.266m $24.803b $587 7.197m $50.951b $557

Note: the average monthly payment does not exactly equal the average monthly payment. The difference might reflect administrative costs, but it is unclear.
(a) Which program experienced the greatest percent increase in average monthly payment?

Old-age benefits increased by (845-603)/603 = 40 percent. Disability benefits increased by (787-587)/587 = 34 percent. Survivors benefits increased by (810-557)/557 = 45.4 percent.
(b) Which program experienced the greatest percent increase in the number of beneficiaries? What explains this increase?

Old-age beneficiaries increased by (31.761-28.369)/28.369 = 12.0 percent. Disability beneficiaries increased by (6.675-4.266)/4.266 = 56.5 percent. Survivors beneficiaries decreased by (6.981-7.197)/7.197 = 3.0 percent. An empirical regularity is that more and more workers apply for (and receive) disability benefits each year.
3-8. Jacks hourly wage is $60 and the marginal value of his time in the household sector is $25 per hour. Jills hourly wage is $50 and the marginal value of her time in the household sector is $20 per hour. Who will specialize in the household sector and who will specialize in the market sector in this household?

For every dollar of household production Jack makes, he must give up $2.40 (i.e., $60/$25) of labor market earnings. For every dollar of household production Jill makes, she must give up $2.50 (i.e., $50/$20) of labor market earnings. Thus, if someone completely specializes in the household sector, it will be Jack, as this minimizes the amount of labor earnings the household must give up.

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3-9. Jacks hourly wage is $20 and the marginal value of his time in the household sector is $10 per hour. Jills hourly wage is $30 and the marginal value of her time in the household sector is $15 per hour. Who will specialize in the household sector and who will specialize in the market sector in this household?

In this example, Jill is better at both household production and in the labor market. However, both Jack and Jill can trade off market wages for household goods at the rate of 2 to 1. There is, therefore, no kink in the household opportunity frontier. Put differently, it does not matter in terms of maximizing the size of the opportunity set if the first hour allocated to the labor market is allocated by Jack or by Jill. Suppose both Jack and Jill have 10 hours a day to allocate to either the household sector or to the labor market. Also suppose that initially both Jack and Jill are allocating all their time to the household sector, so that they are at point E in the figure below. If Jill is the first person to allocate time to the labor market, then specialization (with Jill spending all of her time in the labor market and Jack devoting all his time to the household) occurs at point F. The household then consumes $100 of household goods and $300 of market goods. If Jack is the person who devotes the first hour to the labor market, the point of specialization is reached at point G. At this point, Jack devotes all his time to the labor market and Jill devotes all her time to the household sector. The household then consumes $200 of market goods and $150 of household goods. Depending on the shape of the households indifference curves, the couple might decide to specialize by choosing either point F or point G.
Market Goods ($) 500

Jack and Jills Opportunity Frontier 300 Jills 200 150 G F

Jacks 100 150 E 250 Household Goods ($)

3-10. Consider Table 568 of the 2002 U.S. Statistical Abstract. (a) What has been the general trend in the labor force participation rate of married males over the last 30 years? Consider four age groups: 1619, 2044, 4464, and 65+. For each group, how has their labor force participation rate changed over this time period? Why?

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In general, male labor force participation has fallen from 86 percent in 1970 to 77.4 percent in 2001. This dramatic fall, however, masks a few underlying patterns. First, there has been a marked decline in LFP by males aged 16 19 as many more people are graduating high school and attending college in 2001 than in 1970. Second, males aged 20 44 have experienced a slight decline in labor force participation (from about 98 percent to 96 percent), possibly due to the housedad phenomenon. Third, the labor force participation rate of males aged 45 to 64 has fallen from 91.2 percent in 1970 to 83.8 percent in 2001. This mostly reflects the ability (and willingness) of more and more men to retire earlier than the fullbenefits Social Security retirement age of 65. Fourth, the labor force participation rate of males 65 or older has also fallen markedly, indicating less need for retirees to supplement their income.

(b) What has been the general trend in the labor force participation rate of married females over
the last 30 years? Consider four age groups: 1619, 2044, 4464, and 65+. How has the female labor force participation rate changed over this time period for each of these groups? Do the changes for women mirror the changes for men? Why?

In general, female labor force participation has increased from about 40.4 percent in 1970 to 61.4 percent in 2001. Unlike for males, however, this change is fairly universal across age categories. Thus, although the labor force dynamics discussed in part (a) certainly apply to women as well, the overwhelming force during the last 30 years, as far as women are concerned, is simply the massive entry of women into the labor force.
3-11. Consider the statistics reported in Table 569 of the 2002 U.S. Statistical Abstract. Plot the labor force participation rate of single and married women from 1970 to 2000 in five year intervals. Describe any differences or similarities that you see.

The data are: LFPR of Females Year Single Married 1970 56.8 40.5 1975 59.8 44.3 1980 64.4 49.9 1985 66.6 53.8 1990 66.7 58.4 1995 66.8 61.0 2000 69.0 61.3

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Female Labor Force Participation Rates


75 70 65 60 55 50 45 40 35 1970 1975 1980 1985 Year 1990 1995 2000

LFPR

Single Married

The major similarity is that both rates seem to be currently holding steady somewhere around 60 to 65 percent, with single females participating a little bit more. The major difference is that single females reached this level by 1980 and have not changed much since then, whereas married females have shown a slow but steady increase from 1970 until 1990 or 1995.
3-12. Suppose the government grants $2,500 per child to households that have more than two children. Do these child allowances influence the fertility behavior of households who had no children prior to the government program?

The initial budget line (in the absence of a government subsidy) is AC in the figure below the government subsidy that kicks in at 2 children shifts the budget line to ABDE. Note that the DE segment of the new budget line is flatter than the old segment because the amount of the subsidy increases the more children the household has. (Think of there being two goods: children and market goods. The subsidy decreases the price of children, thus making the budget line less steep, but only for two or more children.) As drawn, the household will move from having no children to a tangency point on the DE segment, and has slightly more than 2 children. It is evident that the larger the subsidy the more likely that households who had fewer than 2 children before the subsidy will have 2 or more children once the subsidy program goes into effect. It is interesting to note that the subsidy will never entice a household that would otherwise choose to have no children to now have 1 (or any amount less than 2) children.

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Goods

Number of Children

3-13. Under the U.S. estate tax law in effect between 1995 and 2001, very rich households had a tax incentive to transfer some of their estate to their heirs as inter-vivos gifts (gifts from the living to the living) Repealing the estate tax will remove the tax incentive to give inter-vivos gifts. What effect will repealing the estate tax have on the hours worked and retirement age of heirs?

Wealthy households will respond to the tax change by making fewer (and less valuable) inter-vivos gifts. Instead, such households will simply bequeath their estates to their heirs. Thus, expectant heirs will receive less non-labor income presently in exchange for a larger inheritance sometime in the future. Heirs, however, are unable to borrow against their future inheritance. Therefore, the tax change will probably cause future heirs to increase their hours of work (as they have experienced a negative income effect until they receive the inheritance) and will probably cause heirs to retire later in life as they cannot consume their inheritance to fund their retirement until they have actually received the inheritance.

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