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Chapter 5

Chapter 5 Typical Question and Answers

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University of Toronto St. George
George Ignatieff

CHAPTER 5 5-1. Suppose the labor supply curve is upward sloping and the labor demand curve is downward sloping. The study of economic trends over a particular time period reveals that the wage recently fell while employment levels rose. Which curve must have shifted and in which direction to produce this effect? If the supply curve does not shift, all wage and employment movements must occur along the supply curve, so that the wage rate and the employment level must move in the same direction. Because the wage went down while employment went up in the situation described in the question, it must have been the case that the supply curve shifted outwards (to the right). We do not have enough information to determine whether the demand curve shifted as well. 5-2. It takes time to produce a new economist, and prospective economists base their career decision by looking only at current wages across various professions. Further, the labor supply curve of economists is much more elastic than the labor demand curve. Suppose the market is now in equilibrium, but that the demand for economists suddenly rises because a new activist government in Washington wants to initiate many new programs that require the input of economists. Illustrate the trend in the employment and wages of economists as the market adjusts to this increase in demand. Initially, the market is in equilibrium at a wage0wand an employment level of E .0The increase the demand for economists results in a new equilibrium wage of w 1and a new equilibrium employment level of E1. However, the demand for economists in the short-run is inelastic at E0, so the demand increase simply leads to a rise in the wage of economists (as indicated by point 1). In the next period, students believe this wage will persist and oversupply the market so that the cobweb leads to a new wage at point 2. In the next period, students undersupply (because the wage is too low) and the cobweb leads to a new wage at point 3, and so on. Because of the relative elasticities of supply and demand (as drawn), the cobweb is exploding and will never converge to a stable equilibrium. 29 Wage D 1 3 S D 0 1 w 1 w 0 2 E0 E1 Employment 5-3. Suppose the supply curve of physicists is given by w = 10 + 5E, while the demand curve is given by w = 50 – 3E. Calculate the equilibrium wage and employment level. Suppose now that the demand for physicists increases and the new demand curve is given by w = 70 – 3E. Assume this market is subject to cobwebs. Calculate the wage and employment level in each round as the wage and employment levels adjust to the demand shock. (Recall that each round occurs on the demand curve – when the firm posts a wage and hires workers). What is the new equilibrium wage and employment level? The initial equilibrium is given by 10 + 5E = 50 – 3E. Solving these two equations simultaneously implies that w = $35 and S = ED= 5. When demand increases to w = 70 – 3E, the new equilibrium wage is $47.5 and the equilibrium level of employment is 7.5. Round Wage Employment 1 $55.0 5 2 $43.0 9 3 $50.2 6.6 4 $45.9 8.0 5 $48.4 7.2 6 $46.9 7.7 7 $47.8 7.4 8 $47.2 7.6 The table gives the values for the wage and employment levels in each round. The values in the table are calculated by noting that in any given period the number of physicists is inelastically supplied, so that the wage is determined by the demand curve. Given this wage, the number of economists available in the next period is calculated. By round 7, the market wage rate is within 30 cents of the new equilibrium. 30 5-4. The 1986 Immigration Reform and Control Act (IRCA) made it illegal for employers in the United States to knowingly hire illegal aliens. The legislation, however, has not reduced the flow of illegal aliens into the country. As a result, it has been proposed that the penalties against employers who break the law be increased substantially. Suppose that illegal aliens, who tend to be less skilled workers, are complements with native workers. What will happen to the wage of native workers if the penalties for hiring illegal aliens increase? A substantial increase in the penalties associated with hiring illegal aliens will likely reduce the number of illegal aliens entering the United States. The effect of this shift in the size of the illegal alien flow on the marginal product (and hence the demand curve) of native workers hinges on whether illegal aliens are substitutes or complements with natives. As it is assumed that natives and illegal aliens are complements, a cut in the number of illegal aliens reduces the value of the marginal product of natives, shifting down the demand for native labor, and decreasing native wages and employment. 5-5. Suppose a firm is a perfectly discriminating monopsonist. The government imposes a minimum wage on this market. What happens to wages and employment? A perfectly discriminating monopsonist faces a marginal cost of labor curve that is identical to the supply curve. As a result, the employment level of a perfectly discriminating monopsonist equals the * employment level that would be observed in a competitive market (at E ) The imposition of a minimum wage at wMIN leads to the same result as in a competitive market: the firm will only want tD hire E workers as wMINis now the marginal cost of labor, buS E workers will want to find work at the minimum wage. Thus, the wage increases, but employment falls. Dollars S w MIN * A w VMP E E D E * E S Employment 31 5-6. What happens to wages and employment if the government imposes a payroll tax on a monopsonist? Compare the response in the monopsonistic market to the response that would have been observed in a competitive labor market. Initially, the monopsonist hiMes E workers at a waMe of w . The imposition of a payroll tax shifts the demand curve to VMP′, and lowers employment to E′ and the wage to w′. Thus, the effect of imposing a payroll tax on a monopsonist is qualitatively the same as imposing a payroll tax in a competitive labor market: lower wages and employment. (It is interesting to note that the same result comes about if the payroll tax is placed on workers, so that the labor supply and marginal cost of labor curves shift as opposed to labor demand.) Dollars MC E S A B w M w′ VMP′ VMP E Employment E′ EM 5-7. An economy consists of two regions, the North and the South. The short-run elasticity of labor demand in each region is –0.5. The within-region labor supply is perfectly inelastic. The labor market is initially in an economy-wide equilibrium, with 600,000 people employed in the North and 400,000 in the South at the wage of $15 per hour. Suddenly, 20,000 people immigrate from abroad and initially settle in the South. They possess the same skills as the native residents and also supply their labor inelastically. (a) What will be the effect of this immigration on wages in each of the regions in the short run (before any migration between the North and the South occurs)? There will be no effect on the North’s labor supply in the short run, so the wage rate will not change there. In the South, labor supply will have increased by 5 percent, so the wage rate must fall by 5/(0.5) = 10 percent (recall that the elasticity of labor demand is -0.5, so a one percent decrease in wages would have been generated by a 0.5 percent expansion of the labor supply). The new hourly wage in the South, therefore, is $13.50 and total employment in the South is 420,000. 32 (b) Suppose 1,000 native-born persons per year migrate from the South to the North in response to every dollar differential in the hourly wage between the two regions. What will be the ratio of wages in the two regions after the first year native labor responds to the entry of the immigrants? After the initial migration, we have seen that wages in the South are $13.50 while wages in the North are $15. This difference leads 1,500 natives migrating from the South to the North in the first year. Employment in the North after one year, therefore is 601,500. Moreover, as the elasticity of labor demand in the North is -0.5 and employment has increased by 0.25 percent, the Nort
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