Economics 151A

Professor David Neumark

Problem Set 3
Due Tuesday, March 2
1. The aggregate demand for labor curve is w b a L
d
+ , where w is the wage and a >
0 and b < 0. The aggregate labor supply curve by w d c L
s
+ , where c > 0, d > 0,
and a > c. Labor supply and demand are measured in hours.
a. Graph the labor market equilibrium, and solve for the equilibrium wage and
number of hours, as functions of a, b, c, and d.
Answer:
The labor market equilibrium is shown in the following figure:
We know that at equilibrium, labor demand is equal to labor supply, i.e.
b d
c a
w c a w b d w b a w d c L L
d s

+ + ) ( .
Thus, plugging this value of w in with labor supply or demand, we get
equilibrium number of hours. We will plug value of w in labor demand and
solve for number of hours.
Therefore,
,
_

+
b d
c a
b a L L L
d s
b. Congress is considering raising taxes to finance public health insurance.
Under the Republican plan, workers would be taxed an amount t per hour
worked. Democrats object to taxing workers, and instead propose taxing
employers an amount t for each hour worked by an employee. Using graphs,
show the effects of these alternative tax plans on wages and on employment.
Answer:
This argument is not valid. We can show this using the following Figures 1 and 2.
Figure 1 shows the case when impose tax is on employees and Figure 2 shows the
case for payroll tax on employers. Tax on employees shifts the labor supply curve to
the left resulting in lower employment (E -> E). Note that w is greater than w, but the
employee gets w minus the tax. Tax on employees on the other hand, shifts the labor
demand curve downwards which results in lower wages (w -> w) and lower
employment (E -> E). Thus, we see that the impact is same in both the cases, and thus
it is irrelevant on whom the tax is imposed. Note that the graph doesnt quite establish
that the effects are equaljust that they go in the same direction. You did not have to
show the equality with math, but you should have at least cited the result.
c. Solve for the equilibrium wage and number of hours under each plan.
Answer:
Tax on employees:
w b a L
d
+ and ) ( ) ( t w d c t w d c L
s
+ + .
Equilibrium =>
b d
t d c a
w t d c a w b d w b a t w d c L L
d s

+
+ + + ) ( ) (
Therefore,
b d
t d b bc ad
b d
t d c a b b d a
b d
t d c a
b a L L H
d s

+ +

,
_

+
+
) ( ] [
'
Tax on employers:
) ( t w b a L
d
+ + and w d c L
s
+ .
Equilibrium =>
b d
t b c a
w t b c a w b d t w b a w d c L L
d s

+
+ + + + ) ( ) (
Therefore,
b d
t d b bc ad
b d
t b c a t b b d a
b d
t b c a
t b a L L H
d s

+ + +

,
_

+
+ +
) )( 1 ( ] [
) 1 (
d. Which plan is better for workers? Show this explicitly.
Answer:
Neither plan is better for workers. The level of employment is the same under
either plan. And the wages are equivalent under either plan. The wage paid
under the employer-financed is equal to the net income for workers, or the
wage minus the tax, under the worker-financed plan. Algebraically,
w
b d
t d c a
t
b d
t b c a
t w

+

, where t w is the wage that
workers get when employers are taxed and w is the wage that workers get
under when employees are taxed. We can also see from part c that H is
same as ' H i.e. hours worked is same under both plans.
e. If a = 10, b = -1, c = 0, and d = 1, calculate the deadweight loss from a
payroll tax of 0.2.
Answer:
Pretax:
5
2
10
) 1 ( 1
0 10

b d
c a
w
and
5 5 ) 1 ( 10 + + bw a H
Post-tax:
9 . 4
2
8 . 9
) 1 ( 1
2 . 0 ) 1 ( 0 10


+

b d
t b c a
w
and
9 . 4
2
8 . 9
) 1 ( 1
2 . 0 1 ) 1 ( 0 10


+

b d
t d b bc ad
H
.
Dead-weight loss = 01 . 0 1 . 0 2 . 0 5 . 0
2
1
H t . This is the area of the
triangle between the non-tax equilibrium wage at the non-tax equilibrium H,
the wage workers take home under the tax at the post-tax H, and the wage
employers pay under the tax at the post-tax H.
2. A few years ago, the city of Santa Monica was considering enacting a living wage
for hotel workers. Opponents argued that mandating a wage above the equilibrium
wage level would increase hotel prices, lower demand for hotel rooms, and hence
reduce employment of hotel workers. Proponents, however, introduced evidence that
during the 1990s, prices for hotel rooms increased and wages of hotel workers
increased, yet over the same period the quantity of hotel rooms sold increased and
hotel worker employment increased. They argued, based on this evidence, that the
living wage law, even if did increase hotel prices, would not reduce hotel employment
and would in fact be more likely to increase it. Evaluate the argument of the living
wage proponents.
Answer:
This is not a valid argument. This is because mandating a wage above the equilibrium
wage level would shift the supply curve in the market for hotels to the left, which in
turn will increase hotel prices, lower demand for hotel rooms, and hence reduce
employment of hotel workers. In contrast, we know that the 1990s was a boom period
where economic performance was good and thus we could have seen that prices for
hotel rooms increased and wages of hotel workers increased, yet over the same period
the quantity of hotel rooms sold increased and hotel worker employment increased,
due to an increase in the demand (and hence a outward shift of the demand curve) in
the market for hotels. Thus, these are two unrelated arguments. The impact of living
wage should be a supply side argument.
3. For this problem, you will study developments in unemployment during the current
recession, using data from the U.S. Bureau of Labor Statistics (or elsewhere), at
www.bls.gov. In all cases display the data in a graph (or graphs), and provide some
text describing what you find.
a. Figure 12.5 in Borjas compares the official unemployment rate with two
alternative measures that include different measures of hidden
unemployment. Use data from the U.S. Bureau of Labor Statistics (or
elsewhere) to describe what has happened to these three different measures of
unemployment during the current recession.
b. How has the unemployment rate changed for men and for women during the
current recession? If you find evidence of differences, try to explain why (and
dont just speculate; use the BLS data to try to introduce evidence for your
argument).
Note: The answers to this question should be typed up, not hand-written.
4. A labor economist estimates a regression of log earnings on schooling (S), experience (E),
ability (A, as measured by IQ), and interactions between schooling and experience, and
ability and experience, and obtains the following estimates (assume all estimates are
statistically significant):
ln(Y) = 9.90 + .07S + .03E + .04A .005SE + .008AE
Is this evidence more consistent with the human capital model, or the signaling model?
Explain your answer.
Answer:
If education has merely a signaling effect, then employers would only rely on it initially. Once
an employer observed an employee directly, she could make inferences about productivity
without further relying on the information contained in a college degree. Statistically, we
should find that, as a worker gains more experience, underlying ability becomes a better
predictor of earnings than does schooling. In the regression results above, ability becomes a
stronger predictor of earnings with age (embodied in the positive coefficient on AE), while
schooling becomes a weaker predictor of earnings with age (embodied in the negative
coefficient on SE). These results provide evidence that supports the signaling model of
education.
5. A high school graduate is considering whether to attend college. He predicts that his
earnings if she doesn't attend college will be $25,000 per year (real). He predicts that his
earnings after four years of college will be $37,000. Tuition costs are $5,000 per year.
Assume that college begins at age 18, and ends at age 22, and that he will work until age 65.
(You will find it useful to use a spreadsheet program to solve this problem.)
a. Write out the equation used to evaluate the net benefit of a college education, for
discount rate r.
Answer:
The net present value of a college education is:
( ) ( )
18 18
64 21
1 1
(1 ) (1 )
22 18
t t
C HS HS C
r r
t t
NPV Y Y Y C

+ +

+

,
where
HS
Y is the annual income of a high-school graduate,
C
Y is the annual income of
a college graduate, and
C
C is the annual, direct cost of college (i.e., tuition).
b. If the discount rate is 5%, what is the value of the net benefit (which could be
positive or negative) of a college education?
Answer:
Plugging in the relevant values in the above NPV expression given in part (a), we get
NPV = $70,184.38.
c. What is the internal rate of return for the college investment that this person faces?
Answer:
To get the internal rate of return (IRR), we set the present value of benefits equal to the
present value of costs, then solve for the discount rate. You can do this in Excel by
altering the discount rate directly until the NPV is very close to zero. We find that the
IRR is approximately 8.55%.
d. Suppose the high school graduate estimates that his probability of dying in any
year is .01 (so his probability of surviving is .99). How should the equation in part a
be modified to account for this?
Answer:
( ) ( ) ( ) ( )
64 21
18 18
0.99 0.99
1 1
22 18
t t
C HS HS C r r
t t
NPV Y Y Y C

+ +

+

e. Recalculate the present value of the net benefit of a college education with the
mortality risk assumed in part d.
Answer:
Plugging in the relevant values in the above NPV expression given in part (d), we get
NPV = $42,640.94
f. Returning to parts a and b, suppose we assume that instead of working until age 65,
the individual works forever. How can we calculate the net benefit of a college
education? Do the calculation.
Answer:
To solve this question, we have to use the shortcut equation for simplifying the
discounting summation. This shortcut states:
( )
1
1
1 1
1
1
1
1 (1 )
1
T
r
t
r
T
r
t
+

.
We can apply this shortcut to an infinite sum by taking the limit:
( )
1
1
1 1 1 1 1 1
1 1 1 1 1
1
1 0 1 1 1 1 1
1 1 (1 ) (1 )
1 1
lim lim
T
r
t t r r
r r r r r
T
r
r
r r
T T
t t
+
+
+ + + + +

+
+ +




.
Now, we can change the NPV equation from part (a):
( ) ( )
( ) ( )
18 18
18 18
21
1 1
(1 ) (1 )
22 18
21 21
1 1 1
(1 ) (1 )
18 18
t t
t t
C HS HS C
r r
t t
r
C HS HS C r
r r
t t
NPV Y Y Y C
Y Y Y C

+ +

+
+ +

+
_
+

,


This gives us a net present value of $95,623.58.
6. A high school student deciding about attending college predicts that his earnings without a
college education will be $30,000 per year (real). To decide whether college will be a good
investment, he asks a number of his older brother's friends, who have just complete college,
how much they earn. He finds that, on average, their salaries are also $30,000 per year, and
based on this decides that it doesn't make sense for him to invest in a college education.
a. Even if he and his brother's friends are equal ability, explain why this may not be a
good basis for making his educational investment decision. Does he likely overstate
or understate the returns on investing in a college education?
Answer:
The student is ignoring the fact that individual who invest in human capital by
attending college are also more likely to invest in human capital after they finish
college. These individuals will experience a drop in earnings immediately after college
as they continue this investment with on-the-job training. In the graph below, observe
the drop in earnings for a college-educated worker who continues HCI throughout the
career. Its quite possible that someone making such an investment would have
earnings as low as a high-school-educated worker for some period of time during the
initial investment.
b. What would be a better (if more complicated) strategy for figuring out whether a
college education is a good investment?
Answer:
Ideally, the student could ask individuals with and without a college education across
a range of ages their earnings. If the student could ask only a single person, he should
ask a college-educated worker who is at the overtaking age (see the graph above).
This would correct for the initial drop in earnings for a worker who invests in on-the-
job training immediately after college.
7. Suppose that real earnings throughout the career are Ys for years of schooling s, and that
workers work for n years after leaving school. If we use continuous compounding of interest,
rather than annual, then the present value Vs of income with years of schooling s is

s n
s
rt
s s
dt e Y V .
Similarly, with no schooling, earnings are Y0 and

n
rt
dt e Y V
0
0 0
.
a. Explain why we should expect Vs = V0.
Answer:
Suppose that Vs > V0, then many people will choose to invest in human capital and get more
education. As the supply of highly educated workers increases, the price of highly educated
labor will decrease in order for the labor market to reach equilibrium. This readjustment will
stop at the point that Vs = V0.
b. Assuming Vs = V0, show that the following equation holds: rs Y Y
s
+ ) ln( ) ln(
0
.
Answer:
If Vs = V0, then
0
0
0
0
0
( ) 0
( ) 0
0
0
0
0
1
( 1) 1
rt rt
s
n s n
rt rt
s
s
n s n
e e
s r r
s
Y Y r n s rs rn r
r r
r n s rs rn r
s
rn rs rs rn
s
rs rn rn
s
s
Y e dt Y e dt
Y Y
e e e e
Y e e Y e e
Y e e e Y e
Y e e Y e
Y Y

+

+

+
+

1 1
] ]
1 1
] ]
1 1
] ]
1 1
] ]
1 1
] ]

0
ln ln
rs
s
e
Y Y rs +
c. According to this model, if we estimate a regression of log earnings on years of schooling,
what is the interpretation of the coefficient on years of schooling?
Answer:
Given the explanation in part (a), we are estimating the internal rate of return of education i.e.
for each additional year of schooling.