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# PERECON

REVIEWER
CHAPTER 2
5. From Table 2.2, the CPI (with a base of 100 in 19821984) rose from 130.7 in 1990 to 201.6 in 2006.
The federal minimum wage (nominal hourly wage) in 1990 was \$3.80, and it was \$5.15 in 2006. Calculate
the minimum wage in real (19821984) dollars. Did the federal minimum wage increase or decrease in real
dollars from 1990 to 2006?

Answer:
Real hourly minimum wage in 1990 = nominal wage in 1990/CPI in 1990
= (\$3.80/130.7) * 100
= \$2.91
Real hourly minimum wage in 2006 = nominal wage in 2006/CPI in 2006
= (\$5.15/201.6) * 100
= \$2.55
The federal minimum wage decreased in real dollars from 1990 to 2006.
7. From the original demand function in Problem 6 (see table), how many cashiers would have jobs if the
wage paid were \$8.00 per hour? Discuss the implications of an \$8 wage in the market for cashiers.

Answer:
If cashiers are being paid \$8.00 per hour, they are being paid more than the market equilibrium
wage for their job. At \$8.00 per hour, employers will hire 110 cashiers, but 175 workers are available
for work as a cashier. There are 65 workers who would like a job as a cashier at a wage of \$8.00 per
hour but cannot get such a job. Because a labor surplus exists for jobs that are overpaid, a wage
above equilibrium has two implications. First, employers are paying more than necessary to produce
their output; they could cut wages and still find enough qualified workers for their job openings. In
fact, if they did cut wages, they could expand output and make their product cheaper and more
accessible to consumers. Second, more workers want jobs than can find them. If wages were reduced
a bit, more of these disappointed workers could find work.

PERECON REVIEWER

CHAPTER 3
1. An experiment conducted in Tennessee found that the scores of second graders and third graders on
standardized tests for reading, math, listening, and word study skills were the same in small classrooms
(13 to 17 students) as in regular classrooms (22 to 25 students). Suppose that there is a school that had 90
third graders taught by four teachers that added two additional teachers to reduce class sizes. If the
Tennessee study can be generalized, what is the marginal product of labor (MPL ) of these two additional
teachers?
Answer: The marginal product (as measured by these test scores) is 0.
3. Suppose that the supply curve for lifeguards is LS = 20 , and the demand curve for lifeguards is
LD = 100 - 20W, where L = the number of lifeguards and W = the hourly wage. Graph both the demand
and supply curves. Now, suppose that the government imposes a tax of \$1 per hour per worker on
companies hiring lifeguards. Draw the new (after-tax) demand curve in terms of the employee wage.
How will this tax affect the wage of lifeguards and the number employed as lifeguards?
Answer: See the figure below. Since the supply curve is vertical, the workers will bear the entire tax.
The wage will fall by \$1 per hour, from \$4 to \$3

5. (Appendix) The Hormsbury Corporation produces yo-yos at its factory. Both its labor and capital
markets are competitive. Wages are \$12 per hour, and yo-yo-making equipment (a computer controlled
plastic extruding machine) rents for \$4 per hour. The production function is q = 40 K0.25 L0.75, where q =
boxes of yo-yos per week, K = hours of yo-yo equipment used, and L = hours of labor. Therefore
MPL = 30 K0.25 L-0.25, and MPK = 10 K-0.75 L0.75. Determine the cost-minimizing capital-labor ratio at this
firm.
Answer:
(Appendix) As the chapter explains, to minimize cost, the firm picks K and L so that W/MPL = C
/MPK , where C is the rental cost of capital. Rearrange this W /C = MPL /MPK and substitute in the
information from the problem:
12/4 = 30K0.25L-0.25/ 10K-0.75L0.75
3 = 3K/L
K= L

PERECON REVIEWER
7. (Appendix) Creative Dangles is an earring design and manufacturing company. The production function
for earrings is Q = 25 KL, where Q = pairs of earrings per week, K = hours of equipment used, and
L = hours of labor. Workers are paid \$8 per hour, and the equipment rents for \$8 per hour.
a. Determine the cost-minimizing capital labor ratio at this firm.
b. How much does it cost to produce 10,000 pairs of earrings?
c. Suppose the rental cost of equipment decreases to \$6 per hour. What is the new cost-minimizing capitallabor ratio?
Answer:
a. Pick K and L so that (MPL /MPK ) = W /C, or (25K /25L ) = 8/8 = 1.
b. Since the cost-minimizing capital-labor ratio is 1, the firm should use equal amounts of capital and
labor. To produce 10,000 pairs of earrings, the calculation is as follows:

c. Costs are minimized when MPL /MPK = W /C. MPL equals 25K, and MPK equals 25L , so their ratio
equals K /L. For costs to be minimized, K /L must now equal 8/6, meaning that the capital-labor
ratio rises from 1 to 1.33. Once capital becomes cheaper, capital is substituted for labor.

CHAPTER 4
5. Union A faces a demand curve in which a wage of \$4 per hour leads to demand for 20,000 person-hours,
and a wage of \$5 per hour leads to demand for 10,000 person hours. Union B faces a demand curve in
which a wage of \$6 per hour leads to demand for 30,000 person-hours, whereas a wage of \$5 per hour leads
to demand for 33,000 person-hours.
a. Which union faces the more elastic demand curve?
b. Which union will be more successful in increasing the total income (wages times person-hours) of its
membership?
Answer:
a. The elasticity of demand is defined as the percentage change in employment divided by the
percentage change in the wage. Using the starting values for employment and wages as our bases, the
percentage change in employment of Union As members when the wage rises from \$4 to \$5 (a 25%
increase) is (10,000 - 20,000)/20,000or a 50% decrease in employment. Thus, the elasticity of
demand for As members is - 50%/25% = - 2. For Union B, a wage decrease from \$6 to \$5 (a 16%
decrease) is associated with an increase in employment from 30,000 to 33,000a 10% increase. The
elasticity of demand facing B is therefore 10%/- 16% = - 0.625. The demand curve facing A is more
elastic than the one facing B.
b. One cannot say which union will be more successful in increasing its members total earnings. This
depends upon a number of factors, including the bargaining power of the two unions and the firms
with which they deal. It is true, however, that the union with the more elastic demand curve will
suffer a larger percentage employment loss for any given percentage increase in wages, and this is
likely to reduce its incentive to push for large wage gains. Thus, the union facing the less elastic
demand curve is likely to be more successful in raising its members wages.

PERECON REVIEWER
CHAPTER 5
1. Suppose a firms labor supply curve is E = 5W , where W is the hourly wage.
a. Solve for the hourly wage that must be paid to attract a given number of workers (E ) to the firm.
b. Express the total hourly labor cost associated with any given level of employment.
c. Express the marginal expense of labor (MEL ) incurred when hiring an additional worker.
Answer:
a. E = 5W, so W = 0.2E . Thus, the wage must rise by 20 cents for every one person increase in
desired number of employees.
b. Total labor costs (C ) are EW, so C = E (0.2E ) = 0.2E2 .
c. The marginal expense of labor (MEL ) is found by taking the derivative of C with respect to
E : dC /dE = 0.4E . Note that while wages must rise by 20 cents for every additional employee
desired, the marginal expense of labor rises by 40 cents (refer back to footnote 7 in the text).
5. The supply of labor is given in the following table for Teddys Treats, a dog biscuit company, which is a
profit-maximizing monopsonist.

a. Calculate the total labor cost and the marginal expense of labor for each level of employment.
b. Draw the supply of labor curve and the marginal expense of labor curve
Answer:
a. The total labor cost is equal to the offered wage * supply of labor. The marginal expense of labor is
equal to (total labor cost)/ (supply of labor). (See the following table.)

b.

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9. The following table gives the quantity of labor, the offered wage, and the MRPL at Toasty Tasties, a
restaurant that specializes in breakfast and lunch.

## a. Calculate the marginal expense of labor.

b. Draw the supply of labor, the marginal expense of labor, and the MRPL curves at Toasty Tasties.
c. To maximize profits, how many hours of labor should be hired? What wage will the employer offer?
d. What would happen if some nonmarket force were to compel the firm to pay its employees \$14 per
hour?
e. What would happen if some nonmarket force were to compel the firm to pay its employees \$26 per hour?
f. What would happen if some nonmarket force were to compel the firm to pay its employees an hourly
wage that is larger than \$26 per hour?
Answer:
a.

b.

c. The profit-maximizing firm will determine the quantity of hours by equating MEL with MRPL
and offer a wage as indicated by the supply of labor curve. At Toasty Tasties, 8 hours of labor will be
employed at a wage of \$12 per hour.
d. If the mandated wage is \$14 per hour, there will be an increase in the number of hours employed
to 9 hours.
e. If the mandated wage is \$26 per hour, there will be 8 hours of labor employed.
f. If the mandated wage is above \$26 per hour, there will be fewer than 8 hours of labor employed.

PERECON REVIEWER
CHAPTER 6
1. When the Fair Labor Standards Act began to mandate paying 50 percent more for overtime work, many
employers tried to avoid it by cutting hourly pay so that total pay and hours remained the same.
a. Assuming that this 50 percent overtime pay premium is newly required for all work beyond eight hours
per day, draw a budget constraint that pictures a strategy of cutting hourly pay so that at the original hours
of work, total earnings remain the same.
b. Suppose that an employer initially paid \$11 per hour and had a 10-hour workday. What hourly base
wage will the employer offer so that the total pay for a 10-hour workday will stay the same?
c. Will employees who used to work 10 hours per day want to work more or fewer than 10 hours in the new
environment (which includes the new wage rate and the mandated overtime premium)?
Answer:
a. See the following figure, where the initial budget constraint is given by ACE. After the new law is
passed, the budget constraint bends upward after 8 hours of work. Thus, the new wage rate and
overtime constraint is given by ABCD , which intersects the old constraint at point C the original
combination of income and working hours (10 hours of work in this example).

b. Initially, earnings were \$11 * 10 = \$110. The new earnings formula is 8W +2 * 1.5W , where
W= the hourly wage. Pick W so that this total equals \$110. Since 11W = \$110, we calculate that W =
\$10 per hour.
c. See the figure above. If the workers were initially at a point of utility maximization, their initial
indifference curve was tangent to the initial budget constraint (line ACE) at point C . Since the new
budget constraint (along segment BD) has a steeper slope (\$15 per hour rather than \$11 per hour),
the workers initial indifference curve cannot be tangent to the new constraint at point C. Instead,
there will be a new point of tangency along segment CD, and hours of work must increasetangency
points along CD lie to the left of point C. (Income in the vicinity of point C is effectively being held
constant, and the substitution effect always pulls in the direction of less leisure whenever the wage
rate has risen.)
3. Suppose you win a lottery, and your after-tax gain is \$50,000 per year until you retire. As a result, you
decide to work part time at 30 hours per week in your old job instead of the usual 40 hours per week.
a. Calculate the annual income effect from this lottery gain based on a 50-week year. Interpret the results in
light of the theory presented in this chapter.
b. What is the substitution effect associated with this lottery win? Explain.
Answer:
a. hours worked per year = hours worked per week * weeks worked per year = (- 10) (50) = 500 Income Effect = (H /Y )|W (constant) = - 500/50000 = - 1/100 Interpretation: For every \$100
increase in non-labor income, you work 1 hour less each year.

PERECON REVIEWER
b. The substitution effect is zero. The lottery win enhances wealth (income) independent of the hours
of work. Thus, income is increased without a change in the compensation received from an hour of
work.
5. Suppose Michael receives \$50 per day as interest on an inheritance. His wage rate is \$20 per hour, and
he can work a maximum of 16 hours per day at his job. Draw his daily budget constraint.
Answer:

7. Teddys daily budget constraint is shown in the following chart. Teddys employer pays him a base wage
rate plus overtime if he works more than the standard hours. What is Teddys daily nonlabor income? What
is Teddys base wage rate? What is Teddys overtime wage rate? How many hours does Teddy need to
work to receive overtime?

Answer:
Teddys non-labor income is \$75. His base wage rate is (\$145 - \$75)/(16 - 9) = 70/7 = \$10 per hour.
His overtime wage rate is (\$325 - \$145)/(9 - 0) = \$180/9 = \$20 per hour. Teddy needs to work at least
7 hours before he receives overtime.